rethinking global economic governance in light of the ...rethinking global economic governance in...
Post on 02-Aug-2020
0 Views
Preview:
TRANSCRIPT
Edited by Richard Baldwin and David Vines
Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations
Rethinking global economic governance in light of the crisis: New perspectives on economic policy foundations
Global governance was, to put it charitably, one of the ‘steadier’ areas of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into uncharted waters.
For scholars, these horrible events were both daunting and exciting. Cherished assumptions had to be binned, but global governance became a top-line issue for heads of state. Economic and political analysis of global governance really mattered.
This Report collects a dozen essays by world-class scholars on the full range of global governance issues including macroeconomics, fi nance, trade, and migration. These refl ect the research of nine research teams working in an EU-funded project known as PEGGED (Politics, Economics and Global Governance: the European Dimensions).
Rethinking Global Econom
ic Governance in Light of the Crisis: N
ew Perspectives on Econom
ic Policy Foundations
Rethinking Global Economic Governance in Light of the Crisis
New Perspectives on Economic Policy Foundations
Centre for Economic Policy Research (CEPR)
Centre for Economic Policy Research3rd Floor77 Bastwick StreetLondon, EC1V 3PZUK
Tel: +44 (0)20 7183 8801Fax: +4 (0)20 7183 8820Email: cepr@cepr.orgWeb: www.cepr.org
© Centre for Economic Policy Research, 2012
ISBN (print edition): 978-1-907142-52-9
Rethinking Global Economic Governance in Light of the Crisis
New Perspectives on Economic Policy Foundations
Edited by Richard Baldwin and David Vines
This book is produced as part of the project ‘Politics, Economics and Global Governance:
The European Dimensions’ (PEGGED) funded by the Socio-Economic Sciences and
Humanities theme of the European Commission’s 7th Framework Programme for
Research. Grant Agreement no. 217559.
Centre for Economic Policy Research (CEPR)
The Centre for Economic Policy Research is a network of over 700 Research Fellows and Affiliates, based primarily in European Universities. The Centre coordinates the re-search activities of its Fellows and Affiliates and communicates the results to the public and private sectors. CEPR is an entrepreneur, developing research initiatives with the producers, consumers and sponsors of research. Established in 1983, CEPR is a Euro-pean economics research organization with uniquely wide-ranging scope and activities.
The Centre is pluralist and non-partisan, bringing economic research to bear on the analysis of medium- and long-run policy questions. CEPR research may include views on policy, but the Executive Committee of the Centre does not give prior review to its publications, and the Centre takes no institutional policy positions. The opinions ex-pressed in this report are those of the authors and not those of the Centre for Economic Policy Research.
CEPR is a registered charity (No. 287287) and a company limited by guarantee and registered in England (No. 1727026).
Chair of the Board Guillermo de la DehesaPresident Richard PortesChief Executive Officer Stephen YeoResearch Director Lucrezia ReichlinPolicy Director Richard Baldwin
Contents
Foreword vii
Introduction 1Richard Baldwin and David Vines
The governance of international macroeconomic relations
The G20MAP, global rebalancing, and sustaining global economic growth 17David Vines
Fiscal consolidation and macroeconomic stabilisation 27Giancarlo Corsetti
The Eurozone Crisis – April 2012 35Richard Portes
The Triffin Dilemma and a multipolar international reserve system 47Richard Portes
Globalisation, financial stability, and global financial regulation
Financial stability: Where it went and from whence it might return 57Geoffrey Underhill
The crisis and the future of the banking industry 67Xavier Freixas
How to prevent and better handle the failures of global systemically important financial institutions 75Stijn Claessens
Cross-border banking in Europe: policy challenges in turbulent times 85Thorsten Beck
Credit default swaps in Europe 95Richard Portes
Global banks, fiscal policy and international business cycles 107Robert Kollmann
The global trade regime
The Doha Round impasse 111Simon J Evenett
The Future of the WTO 121Richard Baldwin
Open to goods, closed to people? 135Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio Zanardi
International migration and the mobility of labour
The Recession and International Migration 143Timothy J Hatton
A dangerous campaign: Why we shouldn’t risk the Schengen-Agreement 157Tito Boeri and Herbert Brücker
vii
This report grows out of research carried out under the auspices of the project Politics,
Economics and Global Governance: The European Dimensions (PEGGED) funded
by the European Union’s Framework Programme. The project, as initially conceived,
involved four workstreams: the governance of international macroeconomic relations;
globalization, financial stability and global financial regulation; the global trade regime;
and international migration and the mobility of labour.
This research agenda was conceived in the spring of 2007. Less than five years have
passed since then, but the economic and political landscape has shifted enormously, and
the early years of the millennium now seem rather distant and remote. Celebrations of
the Great Moderation, arguments for the desirability of independent central banks and
the virtues of markets and the discipline now seem not so much incorrect as somewhat
beside the point.
Faced with this seismic shift, PEGGED responded in a sensible and pragmatic way,
adapting its research agenda to the needs of policymakers as they grappled first with
the turmoil in US subprime markets, then the growing disruption in global financial
markets, and then the collapse of institutions at the heart of the financial system, such
as AIG and Lehman. The output was disseminated through PEGGED working papers
for the most part, but the urgency of the crisis and the need to deliver relevant research
immediately to policymakers meant that new tools were needed. Fortunately, Richard
Baldwin and CEPR had created just the right tool in the summer of 2007 – VoxEU.
VoxEU columns and eBooks proved to be the right way to deliver key research results
in real time. Although VoxEU is a separate venture, independent of PEGGED, VoxEU
has been supported by DG Education and Culture, a happy synergy between EU funding
programmes.
Foreword
viii
Rethinking Global Economic Governance in Light of the Crisis
Richard Baldwin and David Vines have performed an important service by bringing
together in this volume key results from each of the project’s four workstreams. Vines,
a CEPR Research Fellow, has acted as Scientific Coordinator of the PEGGED project
since its inception and has contributed in particular to the project’s work on international
macroeconomic relations. Baldwin, CEPR’s Policy Director, has played an important
role in PEGGED, leading its work on the global trade regime. Bringing together the
results of an ambitious and wide ranging research project such as PEGGED is no easy
task, and we are grateful to David and Richard for doing so.
Thanks are also due to Samantha Reid, who brought this volume to a publishable state
with her customary speed and efficiency. Sam will be leaving CEPR at the end of this
month. We will not be able to take advantage of her skills in future, but this volume is
testimony to her skill and professionalism.
Stephen Yeo
CEO, Centre for Economic Policy Research
13 April 2012
1
A group of scholars banded together in 2007 to propose a four-year research on global
governance – the Politics, Economics and Global Governance: the European Dimensions
(PEGGED for short). While all the research was to be innovative and world-class, the
project was most definitely sailing in familiar seas. Then the storm hit – the global crisis
blew us off-course and into uncharted waters.
Born as the ‘subprime crisis’ in autumn 2007, the crisis metastasized in September
2008 via the financial system. Credit markets froze; equity prices plunged. Emergency
measures by governments and central banks – loosely coordinated by the newly
established G20 Leaders’ Summit – stabilised financial systems. A second Great
Depression was avoided, but sharp credit contractions teamed up with precipitous
declines in business and consumer confidence; the industrialised world was hurled
into recession at an unexpected velocity. The shock transmitted to developing nations
via trade and expectation channels again at an unparalleled pace. This was the Great
Recession and the initial shock continues to reverberate – the Eurozone crisis is the
latest ricochet. With its lethal combination of over-indebted governments, weak banking
system, and a lack of consumer and investor confidence, the Eurozone crisis continues
to threaten European and global economy with another massive shock. The global crisis
is most definitely not over.
For a team of scholars, these horrible events were both daunting and exciting. Many of
our initial assumptions had to be binned, but it made our work radically more relevant
and pressing. For the first time in decades, global governance was at the top of the to-
Richard Baldwin and David VinesGraduate Institute, Geneva and CEPR; Balliol College, Oxford, Australian National University, CEPR, and PEGGED
Introduction
Rethinking Global Economic Governance in Light of the Crisis
2
do lists of heads of state. Economic and political analysis of global governance really
mattered.
While our work is far from over – the European perspective on global governance is still
very much an ongoing effort – the funding and thus the formal project ends this year.
We are marking this with a final PEGGED conference in Brussels on 23 April 2012.
A new ‘Bretton Woods’ moment (in slow motion)
The pre-crisis global governance system, set up in the 1940s, came at lightning speed.
A few dozen meetings established: the UN to keep peace, the IMF to manage the
international monetary system, the World Bank to foster development, and the GATT/
WTO to manage the global trade system. Today sees the world re-crafting this system
in slow motion.
The longstanding partnership between the US and the EU and their joint dominance
– the heart of the Bretton Woods governance system – are rapidly breaking down.
Emerging market economies are shifting economic realities, interdependencies, and
power relationships. While long in train, such sea changes were accelerated by the
impact of the global financial crisis – especially its asymmetric impact on long-term
prospects. Since WWII, the economic prospects have never been dimmer for the rich
nation, or brighter for developing nations. The emerging economies are back on track;
the industrialised nations are looking at a ‘lost decade’.
In this more complex, multipolar, world, the interests of new players need to be
represented, and international cooperation must be organised in new ways. The
economic impact of cross-border integration is coming to constrain national policy
autonomy more than ever before.
Introduction
3
The PEGGED Research Programme
The PEGGED Research Programme has helped European policymakers to construct
and project a vision for this new global system. Within the PEGGED Programme,
political scientists and economists have worked together to develop workable, real-
world policy solutions in four important areas of international cooperation. These four
areas are:
• The governance of international macroeconomic relations
• Globalisation, financial stability, and global financial regulation
• The global trade regime
• International migration and the mobility of labour
Throughout its life, PEGGED has produced a number of working papers on each of
these four topics. The Programme has also produced many policy publications on these
topics, in the form of Policy Briefs, Papers, and Reports. These can all be found on
http://pegged.cepr.org/. PEGGED has also held regular policy events in a number of
places, including Amsterdam, Barcelona, Brussels, Florence, Geneva, London, Lisbon,
Madrid, Oxford, Paris, Pisa, Rome, Tilburg, Tokyo, and Villars. Details of all of these
meetings can also be found at http://pegged.cepr.org/.
In this introductory chapter we briefly describe the chapters included in this Report,
grouping them by the four areas.
The governance of international macroeconomic relations
Global governance made remarkable progress with the establishment of the G20
Leaders’ Summit. The first cooperative steps – coordinated stimulus in reaction to the
global crisis – were easy. Today, with monetary policy at its lower bound and fiscal
policy at its upper bound in the advanced economies, global coordination is far more
difficult. The chapter by David Vines outlines the main economic imbalances that
require coordination: China must move towards a greater reliance on domestic demand;
Rethinking Global Economic Governance in Light of the Crisis
4
the US must secure long-term fiscal consolidation; and Europe must embrace reforms
that will allow southern Europe to grow. The world now needs a group of policymakers,
from a number of countries, who act together so as to carry out the necessary policy
adjustments. The G20 Mutual Assessment Process is a new framework in which these
policymakers may well be able to do what is required.
Initial responses to the crisis led to the accumulation of a vast stock of public liabilities.
Since then, fiscal tightening has become the priority in advanced countries, and
especially across Europe. In his chapter Giancarlo Corsetti asks whether governments
should relent in their efforts to reduce deficits now, when the global economy is still
weak, and policy credibility is far from guaranteed. He draws on two channels of
recent research, which point in opposite directions. Recent work on the effects of fiscal
contraction at the time of a liquidity trap suggests that multipliers may be large in these
circumstances. Empirical evidence confirms this, especially at a times of recession
in the presence of a banking and financial crisis. As a result, if monetary policy is
constrained, there is little doubt that governments with strong credibility should
abstain from immediate fiscal tightening, while committing to future deficit reduction.
However there is a difficulty in following this advice when the government is charged
a sovereign-risk premium, since sovereign risk adversely affects borrowing conditions
in the broader economy. That will cause fiscal multipliers to be much lower. And, due
to the sovereign-risk channel, highly indebted economies can become vulnerable to a
self-fulfilling economic downturn. This poses a dilemma for highly indebted countries:
they may be well-advised to tighten fiscal policies early, even if the effect of this will
be to reduce activity. The presence of such a sovereign-risk channel provides a strong
argument for focusing on ways to limit the transmission of sovereign risk into private-
sector borrowing conditions. Recent unconventional steps by the ECB suggest that this
is possible.
The Eurozone crisis of 2011–12 would have been much easier to contain and resolve
had there been no global financial crisis, and no deep recession in the advanced
countries. As a consequence, Richard Portes argues in his chapter that it is too facile to
Introduction
5
say that the Eurozone crisis is essentially due to inherent faults in the monetary union.
Nevertheless, the crisis has exposed genuine problems that were neither manifest nor
life-threatening before 2008–09. They would not be remedied by exit of a few countries
from monetary union, which would also be deeply harmful to those countries. The
predicaments of the countries at the heart of the crisis (the GIPS – Greece, Ireland, Italy,
Portugal, and Spain) are varied, and, he argues, are not primarily due to membership of
the single currency, nor to fiscal profligacy (except Greece). It is also wrong to reduce
the causes to inadequate ‘competitiveness’ that could be cured by currency devaluation.
Only from 2003–04 were these countries running large current-account deficits within
the monetary union; and these were financed (some would argue caused) by equally
large capital flows from the surplus countries. Germany played the same role in the
Eurozone as China in the global economy. Unlike the US, however, the GIPS were not
‘free spenders’ – they saw a fall in consumption as a share of GDP and a rise in the
investment share during 2000–07. And unlike China, the capital flows from Germany
and France came primarily from banks – they were private not official flows. The
macroeconomic problem in EMU now is the fiscal consequence of the financial crisis
in bank-based financial systems. Creditor countries have been unwilling to let their
banks suffer the consequences of bad loans – rather, they have managed to put the entire
burden on the taxpayers of the debtor countries. This disregards the EU and Eurozone
financial integration that policymakers have promoted. The longer-term refinancing
operation (LTRO) was an inspired move to bypass German objections to the ECB
taking on the lender of last resort (LLR) role. But it is a temporary expedient. The only
stable solution is for the ECB to accept explicitly, in some form, the LLR role. To stop
self-fulfilling confidence crises, the ECB should commit to cap yields paid by solvent
countries with unlimited purchases in the secondary markets. Arbitrage will then bring
primary issue yields down to the capped level. For the long run, debt sustainability
requires economic growth. The current fiscal contraction is contractionary. Austerity
policies are not the solution, but rather a major part of the problem. Moreover, fiscal
contraction together with private-sector deleveraging is not feasible without a current
account surplus. There will be no exit from the current debt traps and stagnation unless
Rethinking Global Economic Governance in Light of the Crisis
6
the surplus countries accept that they must allow the others to run surpluses, so that
either they relax fiscal policy or they adopt policies to reduce private net savings. And
the overall position would improve if the euro were to depreciate significantly – another
reason for further monetary easing.
A second chapter by Richard Portes concerns the Triffin Dilemma and its implications
for moves, at present, towards a multipolar international reserve system. Robert Triffin
set out his supposed dilemma for the international monetary system in the 1960s.
Meeting global demand for liquid reserves required continuously rising holdings of
US dollars by other countries; but that would progressively undermine confidence in
the dollar as a store of value. The contemporary version of this problem starts from the
hypothesis that the global economy faces a shortage of reserve assets (‘safe assets’).
The empirical evidence cited is persistently low real interest rates. The supply of truly
safe assets – US Treasuries – rests on the backing of the US ‘fiscal capacity’. But that
grows only as US GDP grows, and US GDP grows slower than world GDP, which
determines the growth of demand for those assets. Hence there must be a growing
excess demand for safe assets, and we need to move to a multipolar reserve currency
system in which other countries also provide safe assets. But the 1960s story was
wrong, conceptually and empirically, in assuming the US would run current-account
deficits in order to generate foreign dollar holdings; and now, real interest rates have
not been historically low, nor is there a clear definition of fiscal capacity, nor is there
a global liquidity shortage. The world will move towards a multipolar reserve system,
but not because of the Triffin Dilemma. Official reserve holders want to diversify their
portfolios, and the correction of global imbalances will promote this. The emerging-
market countries will develop their domestic financial markets and will have less need
for foreign financial intermediation. Some emerging-market countries may themselves
become reserve suppliers. And more international facilities centred on the IMF could
reduce the demand for reserves for self-insurance. Considering the Triffin Dilemma
undoubtedly helps us to understand the forces underlying the development of the
international financial system. But it is not the source of the system’s problems.
Introduction
7
Globalisation, financial stability, and global financial regulation
The global and Eurozone crises seem to have undermined, perhaps even destroyed,
the traditional foundations for financial stability in the US and Europe. The chapter by
Geoffrey Underhill focuses on recommendations for the provision of financial stability.
The three essential points are: First, there is little new here; the policy dilemmas of today
are longstanding, well known, and can be informed by the host of historical experience
and related research. Second, the potential and more obvious flaws of the pre-crisis
system of financial governance were well known and debated pre-crisis but this did not
prevent the crisis. Unfortunately, most reform proposals are based on such pre-crisis
thinking and are therefore unlikely to achieve the reform goals. Worse, the Eurozone
is descending into modes of crisis resolution that are known to be dysfunctional and
destructive of successful economic growth and development. Third, reform that is more
likely to provide financial stability for the long run requires new thinking. What Europe
needs is new ‘ideational departures’ that draw on established historical experience.
This should include considerable institutional innovation, a reformed policy process,
and institutionalised attention to the political legitimacy and long-run sustainability of
financial openness. This new thinking is needed at both the global and EU levels.
The global economic crisis wreaked enormous social and economic cost on nations in
Europe and beyond. It also shattered confidence in US and European banking systems.
The regulatory reform response has been aimed at curtailing the financial sector’s
excessive appetite for risk. The chapter by Xaiver Frexias argues that for regulation to
prevent future crises, we must understand the causes behind the excessive risk-taking in
the first place. The first step is a working definition of excessive risk-taking. Drawing
on recent research, the author defines it as a level of risk that corresponds to a negative
net investment value. Obviously no well-run bank would knowingly engage in such
projects so the question is: what went wrong to allow such investment? The chapter
points to four possible answers. First managers’ incentives and corporate governance
could have been wrong. Second, the business cycle risks might not have been properly
Rethinking Global Economic Governance in Light of the Crisis
8
factored in (capital is excessively cheap and lending excessively permissive in upturns
with the opposite holding in downturns). Third, regulatory supervision and market
discipline could have failed to curb excesses in boom times. Finally, moral hazard could
explain the problem, namely the idea that banks take too much risk in anticipation of
being bailed out in the event of massive losses.
Massive support has been provided in the ongoing financial crisis to banks and other
financial institutions including support for failed global systemically important financial
institutions (G-SIFIs). Stijn Claessens argues that the ad hoc methods which have been
adopted for this support have led to much turmoil in international financial markets and
worsened the real economic and social consequences of the crisis. He argues that a better
approach to dealing with G-SIFIs is sorely needed. To date, international efforts have
focused on the harmonisation of the rules of supervision and on increasing supervisory
cooperation. Instead, he argues that what is needed is an effective resolution regime,
and that there are three reform models available. The first reform model is a territorial
approach under which assets are ring-fenced so that they are first available for the
resolution of local claims. The second reform model is a universal approach under
which all global assets are shared equitably among creditors according to the legal
priorities of the home country that can help address the global problem. He argues
strongly that we will be driven towards a third intermediate approach, which combines
aspects of the other two. As policymakers realise all too well, however, especially in
Europe today, whatever approach is adopted to the resolution of G-SIFIs, there is a
danger of conflict with three other policy objectives – preserving national autonomy,
fostering cross-border banking, and maintaining global financial stability.
Turning to the banking system, Thorsten Beck points out that the Eurozone crisis is
not only straining banks’ balance sheets, it is straining the cohesion of the EU’s single
banking market. The key source of tension is the close interaction between national
banks and their governments – both through banks’ holdings of their government’s
bonds and the government’s implicit insurance of their banks. This tension raises
fundamental questions about the need for greater institutional underpinnings. Indeed,
Introduction
9
rather than disentangling the sovereign debt and bank crises, recent policy decisions –
such as the ECB’s LTROs – have tied the two closer together.
The problem, according to the author, is that Europe, and especially the Eurozone, did
too little after the 2007–08 crisis to address the institutional gaps needed to ensure a
stable banking market and manage the inter-linkages between monetary policy and
financial stability. EU policymakers are facing the current crisis with too few policy
tools and coordination mechanisms. What is needed is additional policy tools in the
form of macroprudential financial regulation. One tool – monetary policy – is simply
not enough to achieve asset price inflation and consumer price inflation, especially
in a currency union where asset price cycles are not completely synchronised across
countries. Such regulation would have to be applied on the national, but monitored on
the European, level.
Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deeper
crisis – that of a democratic deficit for the necessary reforms to make this monetary
union sustainable in the long run. Political resistance in both core and periphery
countries against austerity and bailouts illustrates this democratic deficit. In the long
term, the Eurozone can only survive with the necessary high-level political reforms.
A further chapter by Richard Portes discusses credit default swaps (CDSs) which are
derivatives; financial instruments sold over the counter. They transfer the credit risk
associated with corporate or sovereign bonds to a third party. The outstanding gross
notional positions in this market exceeded $60 trillion in early 2007 but have since
fallen to a range of ‘only’ $15-20 trillion. The market first caught policymakers’
attention when AIG had to be bailed out because it had written huge amounts of CDS
protection which it could not redeem; and in Europe when Greek sovereign CDS prices
rose dramatically in spring 2010, apparently contributing to a self-fulfilling crisis,
then when the authorities sought to avoid triggering CDS contracts on Greece in the
eventuality of Greek debt default. Portes’ empirical work on Eurozone sovereign CDS
prices during 2004–11 finds that for Eurozone sovereign debt, the CDS and cash market
Rethinking Global Economic Governance in Light of the Crisis
10
prices are normally equal to each other in long-run equilibrium, as theory predicts. One
interpretation is that the market prices credit risk correctly: sovereign CDS contracts
written on Eurozone borrowers seem to provide new up-to-date information to the
sovereign cash market. In the short run, however, the cash and synthetic markets price
credit risk differently to various degrees. Second, the Eurozone CDS market seems
to move ahead of the corresponding bond market in price adjustment, both before
and during the crisis. And CDS contracts clearly do play a useful hedging role. An
alternative interpretation of our results, however, is that the CDS market leads in price
discovery because changes in CDS prices affect the fundamentals driving the prices of
the underlying bonds. If the CDS spread affects the cost of funding of the sovereign (or
corporate), then a rise in the spread will not merely signal but will cause a deterioration
in credit quality, hence a fall in the bond price; and this mechanism could lead to a self-
fulfilling vicious spiral. Recent theoretical work justifies such an interpretation and, in
particular, attributes responsibility to ‘naked’ CDSs, bought by investors who do not
hold the underlying bonds. Portes argues that naked CDSs are indeed destabilising,
both for sovereigns and for financial institutions. The implication for policy is clear:
ban them.
The crisis – which started with the 2007 subprime crisis and exploded into a wider
financial crisis in September 2008 – became the global crisis when it triggered the
sharpest global recession since the 1930s. This chain of events revealed a major fragility
in the global economy, but it also revealed a major hole in economists’ macroeconomic
toolkit. Quite simply, this crisis could not happen in standard, pre-crisis macro theory.
The analytic framework just did not allow for financial intermediaries so macroeconomic
shock could not emanate from the financial sector. Issues like bank balance sheets had
been assumed away.
While filling this lacuna represents a challenge for economic research for years to come,
Robert Kollmann describes several hole-filling elements in his PEGGED-sponsored
research. He has focused on the role of global banks in business cycles in the EU and
in the world economy. Banks that make loans across many nations but have their equity
Introduction
11
base in one connect the state of bank equity markets in one nation to lending and thus
economic activity in many. For example, a loss on bank loans in one country reduces
the global banking system’s capital which in turn triggers a global reduction in bank
lending; a worldwide recession is the result.
The author points out that this economic logic provides a solid basis for policy. The key
role of bank health for the overall economy suggests that government support for the
banking system might be a powerful tool for stabilising real activity in a financial crisis.
The global trade regime
The chapter by Simon Evenett outlines the key factors responsible for the Doha Round
impasse and argues that scholars ought to devote more attention to analysing such
impasses. The emphasis here is not on the daily twists and turns of the Doha Round
negotiations but on the underlying factors that have probably prevented WTO members
from reaching a mutually acceptable deal.
The WTO is widely regarded as trapped in a deep malaise. Richard Baldwin argues
that, in fact, the WTO is doing fine when it comes to the 20th century trade for which
it was designed – goods made in one nation’s factories being sold to customers abroad.
But, he argues, the WTO’s woes stem from the emergence of ‘21st century trade’
(the complex cross-border flows arising from internationalised supply chains) and its
demand for beyond-WTO disciplines. The WTO’s centrality has been undermined as
such disciplines have emerged in regional trade agreements. The implication is clear.
Either the WTO remains relevant for 20th century trade and the basic rules of the road,
but irrelevant for 21st century trade; all ‘next generation’ issues will be addressed
elsewhere. Or the WTO engages in 21st century trade issues both by crafting new
multilateral disciplines – or at least general guidelines – on matters such as investment
assurances, and by multilateralising some of the new disciplines that have arisen in
regional trade agreements. We are presented with a stark choice. The WTO can stay on
the 20th century side-track on to which it has been shunted, or it can engage creatively
Rethinking Global Economic Governance in Light of the Crisis
12
and constructively in the new range of disciplines necessary to underpin 21st century
trade.
Trade policy poses tough questions for policymakers, but nothing like the problems
arising from migration policy choices. Economists have a hard time explaining this
as they typically work with analytic frameworks where trade and migration have
quite similar economic effects. The chapter by Paola Conconi, Giovanni Facchini,
Max Steinhardt, and Maurizio Zanardi discusses recent research that examines the
similarities and differences in voting behaviour in the US Congress on the two issues.
What they find is that voting is influenced by the constituency’s skill mix (with the
impact on trade and migration votes going in the same direction), and party affiliation
leading to divergent voting patterns (Democrats voting in support of liberal immigration
policies but against trade liberalisation). Additionally, the fiscal burden of immigrants
for a constituency dampens the representative’s enthusiasm for liberal migration
policies, but has no impact on trade. The ethnic composition of Congressional districts
also matters with voting for immigration rising with the district’s share of foreign-born
citizens. Taken together, the authors argue that these effects explain why legislators are
more likely to support opening barriers to goods than to people.
International migration and the mobility of labour
Immigration policy is back in European headlines although perhaps not as much as one
would expect given the dire economic straits in many European nations. The chapter by
Tim Hatton admits that economists still do not fully understand how immigration policy
evolves, or why it seems so different now than in the past. Current understanding is
based on four factors. First, rising education levels have led to better informed attitudes
towards immigration, especially as concerns competition of unskilled immigrants.
Second, concerns about the cost of the welfare state are counterbalanced by the way
such safety nets ease worker-specific adjustments. Third, as international cooperation
becomes more pressing on must-do issues like climate change and security issues,
Introduction
13
draconian immigration rules, which could potentially harm such cooperation, are less
likely to be implemented. Nevertheless, such arguments remain speculative and must
be subjected to more rigorous examination.
Playing politics with migration is dangerous but dangerously attractive in today’s
climate of European malaise. The chapter by Tito Boeri and Herbert Brücker examines
the case for more coordinated and forward-looking migration policies in Europe. The
case rests on three key points. First, uncoordinated national policies are not the right way
to govern migration in an area as economically integrated as Europe. Uncoordinated
policies create prisoner’s dilemma situations with every member spending inefficiently
large amounts on border controls, sub-optimal asylum and humanitarian policies, and
inefficiently restrictive policies on illegal immigration. Second, the resulting zero
immigration policy vis-à-vis northern Africa has backfired. Now migration is based
on family reunification, humanitarian migration, and illegal migration. This means
immigrants are, on average, less educated than economic migrants and natives, do not
generally achieve native language proficiency, and typically have a poor performance
in the labour market and education system of the host country. All this feeds back into
negative perceptions thus making economic and social integration even more difficult.
Finally, the authors point out that today incomes in northern African are not much
lower than those in central and eastern Europe at the time of the 2004 EU enlargement.
Moreover much of the north African youth urban labour force is, at least on paper,
relatively well educated. The authors estimate that north African immigration could
create EU economic gains that are larger than those experienced from east European
migration last decade. The key would be to adopt more realistic restrictions vis-à-vis
northern African countries. This skilled immigration would reduce pressures for illegal
migration while creating substantial economic gains in both the receiving and sending
regions.
Rethinking Global Economic Governance in Light of the Crisis
14
Concluding remarks
Plainly more work is needed on this pressing set of issues. Global governance is a work
in progress and scholars have an obligation to continue analysing and informing the
choice governments are making on an almost daily basis. We hope that this collection
of essays provides an accessible bridge to the academic work in the area as well as a
stimulus to others scholars to take the research further and deeper.
5 April 2012
Introduction
15
About the authors
Richard Edward Baldwin is Professor of International Economics at the Graduate
Institute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief of
VoxEU.org since he founded it in June 2007. He was Co-managing Editor of the journal
Economic Policy from 2000 to 2005, and Programme Director of CEPR’s International
Trade programme from 1991 to 2001. Before that he was a Senior Staff Economist for
the President’s Council of Economic Advisors in the Bush Administration (1990–91),
on leave from Columbia University Business School where he was Associate Professor.
He did his PhD in economics at MIT with Paul Krugman. He was visiting professor at
MIT in 2002/03 and has taught at universities in Italy, Germany, and Norway. He has
also worked as consultant for the numerous governments, the European Commission,
OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, his
research interests include international trade, globalisation, regionalism, and European
integration. He is a CEPR Research Fellow.
David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor of
Economics in the Economics Department, Oxford University, and a Fellow of Balliol
College, Oxford as well as Director of the Centre for International Macroeconomics
at Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellow
at the Bank of England, he has advised a number of international organisations and
governmental bodies. He has published numerous scholarly articles and several books,
most recently The Asian Financial Crisis: Causes, Contagion and Consequences, with
Pierre-Richard Agénor, Marcus Miller, and Axel Weber.
17
1 The global policy problem
It is clear that the world needs global rebalancing – at some stage the scale of
international imbalances must be reduced. As is well known, two things are necessary
for this rebalancing: changes in relative absorption between deficit and surplus countries
in the world – including cuts in absorption in the deficit countries - and changes in
relative prices between deficit and surplus countries.
But the world also needs to ensure that the recovery from the global financial crisis is
sustained, ie it needs a satisfactory absolute level of global growth. There are significant
global risks to this outcome:
• Continued deleveraging in many G20 countries;
• A rapid fiscal consolidation in many countries;
• The gradualness of the adjustment in East Asia;
• The macroeconomic outcome of the crisis in Europe.
Unemployment in the US, Europe, and elsewhere in the OECD remains disastrously
high. To solve this unemployment problem will require a sustained global recovery. Yet
financial markets, and policymakers, are now focused on reducing public deficits and
debt. Temporary stimulus packages are unwinding, and fiscal consolidation is setting
in. There is a danger that the attempts to rebalance – including the cuts of absorption in
deficit countries – will add to the attempts to fiscally consolidate, add to the other risks,
and put global growth prospects seriously at risk.
David VinesBalliol College, Oxford, Australian National University, CEPR, and PEGGED
The G20MAP, global rebalancing, and sustaining global economic growth
Rethinking Global Economic Governance in Light of the Crisis
18
In response to this danger, too many countries appear to be looking for export-led
growth. But we cannot nearly all have export-led growth. There only a small number of
countries with an appetite for exports. This is a systemic problem.
The G20 Mutual Assessment Process, or G20MAP, is a new global institutional
structure forum in which this systemic problem is now being tackled.
2 The need for international macroeconomic cooperation
In the period after the Asia crisis there was high saving in emerging market economies
(and elsewhere). East Asia set exchange rates to ensure export-led growth. The US
Federal Reserve set US interest rates. The outcomes ensured satisfactory growth in
both the US, and in other advanced countries, as well as in East Asia (Adam and Vines
2009). Because of high savings the real interest rate needed to be low. This system led
to the Great Moderation – the ‘Greenspan put’ emerged as a part of what happened (as
is well explained in an IMF Staff Note by Blanchard and Milesi Ferreti 2011).
• This system ensured satisfactory global growth;
• It did not require detailed international cooperation in policymaking (Vines 2011b);
but
• It gave rise to global imbalances.
For a time, these imbalances were not treated as a policy problem and removing them
was not a target of international policy. Such a system – with its low interest rates – also
led to high leverage, to financial instability, and ultimately to the global crisis (Obstfeld
and Rogoff 2009).
Global cooperation in response to the crisis was initially easy; the outcome at the G20
summit in London in April 2009 was remarkable. But it was straightforward to bring
about what happened. All countries had an interest in using monetary expansion, and
then fiscal expansion, to avoid global collapse. And the costs of the resulting fiscal
expansion – in the form of ballooning debt –– only gradually led to fiscal crises.
The G20MAP, global rebalancing, and sustaining global economic growth
19
The world is now in a more complex position that it was immediately after the crisis,
and cooperation is now much more difficult. Interest rates are at their zero bound. And,
because of the high levels of public debt, there is little fiscal space.
China is rebalancing its growth model towards one in which there is a more rapid
expansion of domestic demand. But China is necessarily doing this at a slow speed
(Yongding 2009). During this period of adjustment the dollar-renminbi real exchange
rate will continue to be one which leads to East Asia having a large export surplus. At
the same time, world interest rates are too low for China, which continues to attempt to
deal with this difficulty with capital controls.
Europe is in danger of re-creating the global problem at the European level (Vines
2010, 2011a). Countries in the southern European periphery are now embarking on
demanding austerity programmes. The difficulty of adjusting wages and prices in these
countries of the periphery, which are greatly uncompetitive vis-à-vis Germany, creates
a need for the euro to depreciate, so as to encourage growth in these countries. At the
same time, the German economy is difficulty because European interest rates need to
be low. The position in Germany would become even more unbalanced if the euro were
to depreciate further.
And the US is caught in a fiscal trap. The inability of the US political system to promise
longer-term fiscal correction has made it difficult to for the US to sustain its shorter-term
fiscal stimulus. The resulting fiscal withdrawal is part of the reason why unemployment
seems likely to remain so persistent in the US.
Many activities in the US are now globally uncompetitive because of the depreciated
real exchange rates of China and of other East Asian countries. The outcome may well
be one in which the US wishes to have a lower real exchange rate against not just
East Asia, but against Europe as well. Quantitative easing has become a tool which
influences the dollar in this direction. But many activities in the European periphery are
also globally uncompetitive, because of the depreciated real exchange rate of Germany
Rethinking Global Economic Governance in Light of the Crisis
20
within the euro – and also because of the depreciated real exchange rate of China and
other East Asian countries.
All this means that Europe may wish to see the opposite outcome from that desired by
the US – a lower real exchange rate for Europe against both the US and East Asia, in
order for growth in the European periphery to resume. The LTRO of the ECB appears to
be pushing the euro in such a direction. There is, in short, a genuine possibility of policy
conflict over monetary policy, and exchange rates among China, the US and Europe.
Protectionism in trade is another possible response to this problem (Eichengreen and
Irwin 2009). Plainly there is a pressing need for international macroeconomic policy
cooperation.
3 The G20MAP and international macroeconomic cooperation
The G20MAP is in the process of producing a group of policymakers from G20
countries who come to share the ownership of an international cooperative process.
That is, it is creating policymakers who are concerned with the global problem (such
as those mentioned above), rather than being concerned only with national objectives
(IMF 2011a). The aim is to produce something much better than what was achieved
in the IMF’s previous process of multilateral surveillance process, or MSP. The
governance structure of the IMF meant that the US was able to ensure that the IMF
made no criticism of the US as part of the MSP – and was able to ensure that the
IMF did not exercise any sanction on the US – as a response its large current-account
deficit. The Fund was also unable to exercise any sanction on China as a response to its
undervalued exchange rate.
The G20MAP was established at the Pittsburgh G20 summit in 2009. G20 leaders then
agreed that their aim would be to pursue growth collectively. At that meeting, and at
the Seoul summit in 2010, there was an agreement that the objective was a ‘Framework
for Strong Sustainable and Balanced Growth’ where ‘sustainable’ included the need
The G20MAP, global rebalancing, and sustaining global economic growth
21
for global rebalancing. Since then the G20MAP has gone through a number of stages,
some of which are set out in IMF (2011a). It was decided at an early stage that the IMF
would provide technical analysis to support the G20MAP.1
Subsequently it was decided that the Fund would evaluate how members’ macroeconomic
policies should fit together, providing an assessment of whether national policies, taken
collectively, are likely to achieve the G20’s goals. Since then, during 2011, the IMF
carried out a detailed investigation of the policies of a particular set of countries,
rather than just concentrating broadly on the world, or on regions of the world. These
countries were the US, China, Japan, Germany, India, the UK, and France. The decision
as to which particular set of countries to investigate in detail was taken in April 2011,
and depended on a chosen set of indicators. The choice of indicators attracted much
attention at the time. But the most important thing about these indicators is that the
use of them enabled a decision to be made as to which countries would be analysed
in detail. That decision enabled the G20MAP to be given a much clearer focus. The
analyses were published at the time of the Cannes G20 Summit in November 2011. The
IMF also carried out an analysis of how the policy projections of the seven countries,
and of the rest of the world, would fit together into an overall global outcome (IMF
2011b).
These analyses revealed the risks which have been described earlier in this essay. But,
importantly, the IMF was able to identify a number of policy changes which would lead
to a better outcome. These potential policy changes are now on the table for countries to
examine, and respond to, as part of the G20MAP which is taking place in 2012.
The G20MAP is in its early days. Decisions on the possibilities identified by the IMF
will not be immediate.
1 The Framework for Strong Sustainable and Balanced Growth is not just about achieving satisfactory macroeconomic outcomes; it is also concerned with achieving financial stability, with environmental issues, and with the raising of living standards in developing countries. The broader set of international discussions about that wider range of concerns is being assisted by technical inputs from a range of international institutions far beyond the IMF.
Rethinking Global Economic Governance in Light of the Crisis
22
But what has happened already provides a number of useful insights.
• Coordination, of course, works best when countries share a common objective.
This was the case immediately after the crisis. But it has become less so, for reasons
which will be obvious from the earlier part of this essay.
• What is often required for coordination is not so much an agreement to act in the
pursuit of a shared objective but instead a clearer understanding of what other play-
ers intend to do.
Such an understanding will make clearer for each player what that player needs to
do. The G20MAP has engaged a number of international policymakers in a global
policymaking process and seems likely to lead to greater understandings of this kind.
Progress of this kind will not, of course, be immediate, but it may be significant.
Such understandings are especially necessary if the processes of adjustment which are
required will be a gradual. In that case each policymaker needs to be able to trust that
other policymakers will carry out the adjustments which are required of them. I have
described in this essay three kinds of policy adjustments which are necessary:
• That China moves towards a greater reliance on domestic demand;
• That the US moves towards longer-term fiscal consolidation; and
• That Europe moves towards reforms which enable southern Europe to begin to grow
again.
All of these adjustments will be gradual, and all of them need to be carried out in a way
which relies on other policymakers playing their part as well.
The world now needs a group of policymakers, from a number of countries, who act
together so as to carry out the necessary policy adjustments. The G20MAP is in the
process of creating a new global institutional structure, one in which these policymakers
may well be able to do what is required.
The G20MAP, global rebalancing, and sustaining global economic growth
23
References
Adam, C, and D Vines (2009), “Remaking Macroeconomic Policy after the Global
Financial Crisis: A Balance Sheet Approach”, Oxford Review of Economics Policy,
December 25(4): 507–52.
Allsopp, C, and D Vines (2010), “Fiscal policy, intercountry adjustment, and the
real exchange rate within Europe”, in Buti, M, S Deroose, V Gaspar, and J Nogueira
Martins (eds), The Euro: The First Decade. Cambridge: Cambridge University Press.
Also available as European Economy. Economic Papers. No 344. October 2008. http://
ec.europa.eu/economy_finance/publications/.
Blanchard, O, and J Milesi Ferretti (2011), “(Why) should current account imbalances
be reduced?” IMF Staff Note.
Eichengreen, B and D Irwin (2009), “The protectionist temptation: Lessons from the
Great Depression for today” VoxEU.org, 17 March. Available at http://global-crisis-
debate.com/index.php?q=node/3998.
House, B, D Vines, and M Corden (2008), “The IMF”, New Palgrave Dictionary of
Economics, London: Macmillan.
IMF (2010), “Strategies for Fiscal Consolidation in the Post-Crisis World”, paper
prepared by the Fiscal Affairs Department, and available at http://www.imf.org/
external/np/pp/eng/2010/020410a.pdf.
IMF (2011a) “The G-20 Mutual Assessment Process (MAP)”, an IMF Factsheet,
available at http://www.imf.org/external/np/exr/facts/g20map.htm.
IMF (2011b), IMF Staff Reports for the G-20 Mutual Assessment Process, available at
http://www.imf.org/external/np/g20/pdf/110411.pdf.
Obstfeld, M and K Rogoff (2009), “Global Imbalances and the Financial Crisis: Products
of Common Causes”, available at http://elsa.berkeley.edu/~obstfeld/santabarbara.pdf.
Rethinking Global Economic Governance in Light of the Crisis
24
Vines, D (2010), “Fiscal Policy in the Eurozone after the Crisis”, paper presented at a
Macro Economy Research Conference on Fiscal Policy in the Post-Crisis World, held
at the Hotel Okura, Tokyo, 16 November.
Vines, D (2011a), “Recasting the Macroeconomic Policymaking System in Europe”,
Zeitschrift für Staats- und Europeawissenschaften (ZSE) [Journal for Comparative
Government and European Policy], November.
Vines, D (2011b), “After Cannes: The G20MAP, Global Rebalancing, and Sustaining
Global Economic Growth”, available at http://www.bruegel.org/fileadmin/bruegel_
files/Events/Event_materials/AEEF_Dec_2011/David_Vines_PRESENTATION_
UPDATE.pdf.
Yongding, Yu (2009) “China’s Responses to the Global Financial Crisis”, Richard
Snape, Lecture, Productivity Commission, Melbourne, November, available at http://
www.eastasiaforum.org/wp-content/uploads/2010/01/2009-Snape-Lecture.pdf.
The G20MAP, global rebalancing, and sustaining global economic growth
25
About the author
David Vines is Scientific Coordinator of the PEGGED Programme. He is Professor of
Economics in the Economics Department, Oxford University, and a Fellow of Balliol
College, Oxford as well as Director of the Centre for International Macroeconomics
at Oxford’s Economics Department. Formerly a Houblon-Norman Senior Fellow
at the Bank of England, he has advised a number of international organisations and
governmental bodies. He has published numerous scholarly articles and several books,
most recently The Asian Financial Crisis: Causes, Contagion and Consequences, with
Pierre-Richard Agénor, Marcus Miller, and Axel Weber.
27
The initial response to the crisis led to the accumulation of a vast stock of public
liabilities. Since then, fiscal tightening has become the priority in advanced countries,
and especially across all of Europe. The measures adopted so far have not proved a
cure-all for financial market concerns about debt sustainability. Tighter fiscal policy
has, however, coincided with renewed economic slowdown or even contraction, raising
questions about the desirability of fiscal austerity.
The key question is whether governments should relent in their efforts to reduce
deficits now, when the global economy is still weak, and policy credibility is far from
guaranteed. Under what circumstances would it be wise to do this?
Countries fall into three categories. At one extreme we have countries already
facing a high and volatile risk premium in financial markets. At the other extreme
we have countries with strong fiscal shoulders, actually enjoying a negative risk
premium. A third category includes countries not facing a confidence crisis, yet with
inherent vulnerabilities – a relatively high public debt, a fragile financial sector, high
unemployment. The question of how to ensure debt sustainability is vastly different
across these.
By way of example, how much of Italy’s slowdown is due to austerity and how much
is due to the near meltdown of debt last summer? There is little doubt that the credit
crunch which followed the sudden loss of credibility of Italian fiscal policy (whether
or not justified by fundamentals) has a lot to do with the severe slowdown that Italy is
Giancarlo CorsettiCambridge University and CEPR
Fiscal consolidation and macroeconomic stabilisation
Rethinking Global Economic Governance in Light of the Crisis
28
experiencing. The current fiscal tightening is arguably contractionary, but the alternative
of not reacting to the credibility loss would have produced much worse consequences.
Things are more complex for the UK; it hasn’t lost credibility and it borrows at low
interest rates. Does this mean UK policymakers are shooting themselves in the foot?
Are they keeping the economy underemployed for years and thus destroying potential
output with their austerity drive? Or, are they wisely forestalling a bond market rebellion
like those seen on the continent that would prove much costlier?
Much of the work carried out in the PEGGED project over the years provides a
conceptual and analytical framework to address these issues. The question of course
is not only about restoring safer fiscal positions after the large increase in gross and
net public debt in the last few years. Rather, it is about which fiscal policy path would
be most effective in helping the global economy and the economy of the Eurozone
overcome the current crisis.
This issue requires solution both at country-level, and at regional and global level.
International considerations complicate the analysis; a policy which may be perfectly
viable and desirable for a country conditional on an international context, may not work
in different circumstances. The outcome will depend on the degree of international
cooperation, especially in the provision of liquidity assistance and in the establishing of
‘firewalls’ against contagion.
Fiscal policy at a crossroads: Self-defeating tightening in a liquidity trap?
Recent contributions about the mechanism through which fiscal contraction in a
liquidity trap is counterproductive have led to an important change in perspective,
relative to initial views.
A key point here is the recognition that much of the advanced world is currently in an
unemployment and underemployment crisis. Destruction of jobs and firms today may
Fiscal consolidation and macroeconomic stabilisation
29
be expected to have persistent effects on potential output in the future. These effects in
turn translate into a fall in permanent income, and hence demand, today (see DeLong
and Summers 2012 and Rendahl 2012).
In a liquidity trap, this creates a vicious self-reinforcing circle. Today’s unemployment
creates expectations of low prospective employment, which in turn causes an endogenous
drop in demand, reducing activity and raising unemployment even further. This vicious
cycle may have little to do with price stickiness and expectations of deflation at the
zero lower bound, an alternative mechanism which was stressed early on by Eggertsson
and Woodford (2003) and more recently by Christiano et al (2011). Independently of
deflation, the vicious cycle can be set in motion by expectations of lower income when
shocks create a high level of persistent underemployment. Theory suggests that this
effect can be sizeable. The question is its empirical relevance.
The empirical evidence indeed weighs towards large multipliers at a time of recession
and especially at times of banking and financial crises (Corsetti et al 2012), as opposed
to very small multipliers when the economy operates close to potential and monetary
policy is ‘unconstrained’. The point estimate of the multiplier conditional on crises
is of the order of 2 – a value not far from the one used by several governments and
commentators, but higher than most estimates in the literature that fail to distinguish
across different states of the economy. In light of these results, it can be safely anticipated
that the current fiscal contractions will exert pronounced negative effects on output.
It is worth stressing that fiscal adjustment is currently happening at different levels of
government – both central and local. An analysis of spending multipliers at local level
carried out in the context of the PEGGED model suggests that differences in cuts and
budget adjustment at subnational level can also generate sizeable contractionary effects
on the local economy, holding constant the macroeconomic conditions at national level.
This is the paper by Acconcia et al (2011) on provincial multipliers in Italy, which takes
advantage of the quasi-experimental setting generated by the Italian law mandating
the dismissal of city councils on evidence of mafia infiltration. When a city council
Rethinking Global Economic Governance in Light of the Crisis
30
is dismissed, the commissaries sent by the government ensure that the administration
keeps working according to national standards, but suspend public works. This
generates a spending contraction of the order of 20%. The multiplicative effects on
output, calculated holding monetary policy constant, are of the order of 1.2 or 1.4.
This is why, with a constrained monetary policy, there is little doubt that governments
with a full and solid credibility capital should abstain from immediate fiscal tightening,
while committing to future deficit reduction. The virtues of such a policy are discussed
in the aforementioned PEGGED paper by Corsetti et al (2010).
The problem is that, in the current context, promising future austerity alone may not be
seen as sufficiently effective. Keeping markets confident in the solvency of the country
has indeed provided the main motivation for governments to respond to nervous
financial markets with upfront tightening.
The challenge: How to stabilise economies with high and volatile sovereign risk
In a recent PEGGED paper, Corsetti et al (2012) (henceforth CKKM) highlight issues
in stabilisation policy when the government is charged a sovereign-risk premium. The
root of the problem is the empirical observation that sovereign risk adversely affects
borrowing conditions in the broader economy. The correlation between public and
private borrowing costs actually tends to become stronger during crises. Perhaps in a
crisis period high correlation is simply the by-product of common recessionary shocks,
affecting simultaneously, but independently, the balance sheets of the government and
private firms. Most likely, however, it results from two-way causation.
In the current circumstances, there are good reasons to view causality as mostly flowing
from public to private. First, in a fiscal crisis associated with large fluctuations in
sovereign risk, financial intermediaries that suffer losses on their holdings of government
bonds may reduce their lending. Second, both financial and non-financial firms face a
Fiscal consolidation and macroeconomic stabilisation
31
higher risk of loss of output and profits due to an increase in taxes, an increase in tariffs,
disruptive strikes and social unrest, not to mention lower domestic demand.
There are at least two implications for macroeconomic stability of this ‘sovereign-risk
channel of transmission’ linking public to private borrowing costs.
First, if sovereign risk is already high, fiscal multipliers may be expected to be lower
than in normal times. The presence of a sovereign-risk channel changes the transmission
of fiscal policy, particularly so when monetary policy is constrained (because, for
example, policy rates are at the zero lower bound, or because the economy operates
under fixed exchange rates). When sovereign risk is high, the negative effect on demand
of a given contraction in government spending is offset to some extent by its positive
impact on the sovereign-risk premium.
Some exercises by CKMM suggest that, typically, consolidations will be contractionary
in the short run. Only under extreme conditions does the model predict either negative
multipliers (in line with the view of ‘expansionary fiscal austerity’) or counterproductive
consolidations (in line with the view of ‘self-defeating austerity’). To the extent that
budget cuts help reduce the risk premium, there is some loss in output, but not too large.
Second, due to the sovereign-risk channel, highly indebted economies become
vulnerable to self-fulfilling economic fluctuations. In particular, an anticipated fall
in output generates expectations of a deteriorating fiscal budget, causing markets to
charge a higher risk premium on government debt. Through the sovereign-risk channel,
this tends to raise private borrowing costs, depressing output and thus validating the
initial pessimistic expectation.
Under such conditions, conventional wisdom about policymaking may not apply. In
particular, systematic anti-cyclical public spending is arguably desirable when policy
credibility is not an issue. In the presence of a volatile market for government bonds,
however, anticipation of anti-cyclical fiscal policy may not be helpful in ensuring
macroeconomic stability. A prospective increase in spending in a recession may lead to
Rethinking Global Economic Governance in Light of the Crisis
32
a loss of confidence by amplifying the anticipated deterioration of the budget associated
with the fall in output.
This possibility poses a dilemma for highly indebted countries. In light of the above
considerations, countries with a high debt may be well-advised to tighten fiscal policies
early, even if the beneficial effect of such action – prevention of a damaging crisis of
confidence – will naturally be unobservable. From a probabilistic perspective, even
a relatively unlikely negative outcome may be worth buying insurance against if its
consequences are sufficiently momentous. In the current crisis, unfortunately, we know
that such insurance does not come cheap.
Beyond country-level fiscal correction
The near-term costs of austerity mean we should keep thinking about alternatives, such
as making commitments to future tightening more credible (eg the reform of entitlement
programmes). However, the presence of a sovereign-risk channel also provides a strong
argument for focusing on ways to limit the transmission of sovereign risk into private-
sector borrowing conditions.
Strongly capitalised banks are a key element here. The ongoing efforts, coordinated
by the European Banking Authority, to create extra capital buffers in European banks
correspond to this logic. Another element is the attempt by monetary policymakers to
offset high private borrowing costs (or a possible credit crunch) when sovereign-risk
premium is high.
Normally, the scope to do this is exhausted when the policy rate hits the lower bound.
Recent unconventional steps by the ECB, however, suggest that more is possible. The
extension of three-year loans to banks, in particular, appears to have reduced funding
strains, with positive knock-on effects for government bond markets.
These arguments are especially strong, either for countries already facing high interest
rates in the market for their debt, or for countries reasonably vulnerable to confidence
Fiscal consolidation and macroeconomic stabilisation
33
crises. These countries would be ill-advised to relax their fiscal stance. The arguments
apply less to governments facing low interest rates. The main issue is where to draw
the line.
References
Acconcia, A, G Corsetti, and S Simonelli (2011), Mafia and Public Spending: Evidence
on the Fiscal Multiplier from a Quasi-experiment, CEPR DP 8305.
Christiano, L, M Eichenbaum, and S Rebelo.(2011) When is the government spending
multiplier large? Journal of Political Economy, 119(1):78–121.
Cottarelli, C (2012), “Fiscal Adjustment: too much of a good thing?”, VoxEU.org,
February 8.
Corsetti, G, A Meier and G Müller (2009), “Fiscal Stimulus with Spending Reversals”,
CEPR discussion paper 7302, 2009, Forthcoming, The Review of Economics and
Statistics.
Corsetti, G, K Kuester, A Meier, and G Müller (2010), “Debt consolidation and fiscal
stabilisation of deep recessions”, American Economic Review: P&P 100, 41–45, May.
Corsetti, G, K Kuester, A Meier, and G Müller (2012), “Sovereign risk, fiscal policy
and macroeconomic stability”, IMF Working paper 12/33.
Corsetti, G, A Meier, and G Müller (2012) “What Determines Government Spending
Multipliers?” Prepared for Economic Policy Panel in Copenhagen April.
DeLong, B and L Summers (2012) Fiscal Policy in Depressed Economy,
Eggertsson, G B and M Woodford (2003), “The zero interest-rate bound and optimal
monetary policy”, Brookings Papers on Economic Activity, 1:139–211.
Rendahl, P (2012), Fiscal Policy in an Unemployment Crisis, Cambridge: Cambridge
University Press.
Rethinking Global Economic Governance in Light of the Crisis
34
About the author
Giancarlo Corsetti is Professor of macroeconomics at the University of Cambridge. On
leave from the University of Rome III, he previously taught at the European University
Institution, as Pierre Werner Chair, the Universities of Bologna, Yale and Columbia.
His main field of interest is international economics. His main contributions to the
literature include general equilibrium models of the international transmission
mechanisms and optimal monetary policy in open economies, analyses of currency
and financial crises and their international contagion, and models of international
policy cooperation and international financial architecture. He has published articles in
many international journals including American Economic Review, Brookings Papers
on Economic Activity, Economic Policy, Economics and Politics, European Economic
Review, Journal of Economic Dynamics and Control, Journal of Monetary Economics,
Quarterly Journal of Economics, Review of Economic Studies, and the Journal of
International Economics. He has co-authored an award-winning book on the 1992-93
crisis of the European Monetary System, Financial Markets and European Monetary
Cooperation. He is currently co-editor of the Journal of International Economics.
Giancarlo Corsetti is Research Fellow of the Centre for Economic Policy Research in
London, where he serves as Director of the International Macroeconomic Programme;
and a member of the European Economic Advisory Group at CESifo in Munich,
publishing a yearly Report on the European Economy. Professor Corsetti has been a
scientific consultant to the ECB and the Bank of Italy, and a visiting scholar at the
Federal Reserve Bank of New York and the IMF.
35
Richard PortesLondon Business School and CEPR
The Eurozone crisis – April 2012
The Eurozone crisis of 2011–12 is a sequel to the financial crisis of 2008–09. It would
have been much easier to contain and resolve had there been no global financial crisis,
no deep recession in the advanced countries. It is therefore too facile, indeed wrong, to
say that the Eurozone crisis is essentially or even mainly due to inherent faults in the
monetary union. Nevertheless, the crisis has exposed genuine faults that were neither
manifest nor life-threatening before 2008–09. They might have been remedied with
gradual progress towards a deeper economic union. But all that is for the economic
historians. We are where we are, and it is not pretty.
Government bond yields for several of the 17 countries in the economic and monetary
union (EMU) were unsustainable in November 2011. They then fell back, with the
ECB’s longer-term refinancing operation (LTRO). But they are climbing again – more
on that below. The spread over the German ten-year government bond (the Bund) was
close to zero for most of the period from 1999 to 2008. Now, however, of the EMU
government bonds, only Germany is regarded as a risk-free ‘safe asset’. Even that is
not totally clear, since the credit default swap (CDS) premium for Germany was at 110
basis points in November 2011 (it was 40 in July). The CDS market is by no means a
reliable guide to default risk, but it does give information about sovereign bond prices1,
and the message is disturbing.
1 Portes (2010), Palladini and Portes (2011).
Rethinking Global Economic Governance in Light of the Crisis
36
In late 2011, until the LTRO, there were no buyers in the markets for Eurozone
sovereign debt except the ECB, sporadically, and domestic financial institutions under
open or implicit pressure from their governments. Many of those institutions have
used some of their new ECB funding for renewed purchases of their home sovereign
bonds, but this simply exacerbates the already dangerous nexus between fragile banks
and fragile sovereigns. The liquidity crunch of late 2011 has also moderated but could
quickly return. The European Financial Stability Fund (EFSF) could not sell some of
an early November bond issue and is a fragile reed. France has lost its AAA rating,
and all Eurozone banks are under rating review. Deposits in Greek banks have been
falling steadily for many months, and there are signs of similar but slower ‘bank walks’
in other countries deemed at risk. The sovereign CDS market itself is in question,
because the authorities sought to engineer a deep restructuring of Greek debt without
triggering the CDS. This would have shown that the ‘insurance’ provided by CDSs is
not insurance after all. Although eventually the swaps were triggered, the markets are
still very uneasy.
There are bits of good news: ECB monetary policy is still ‘credible’, on the evidence
of market inflation expectations (2.02% at a five-year horizon, 2.22% at a ten-year
horizon, as at 4 April 2012). The underlying bad news there, however, is that the
ECB interest rates have been too high and are still too high despite the cut of 50 basis
points in December 2011. The technocratic prime ministers in Greece and Italy are
very experienced, very able, and fully conscious of what their countries must do to
restart economic growth. That said, they are not elected politicians, and their legitimacy
and authority may be correspondingly limited. Since the necessary measures would
be painful and challenging even with a popular mandate, one may question whether
technocratic governments can carry them out. Resistance in both countries is very
strong.
For the countries at the heart of the crisis but the geographical periphery of the
Eurozone, the sources of their predicaments are varied. Importantly, they are not
primarily due to membership of the single currency, nor to fiscal profligacy. Greece
The Eurozone crisis – April 2012
37
is of course an exception to the latter generalisation, because its fiscal excesses were
both large and duplicitous, partly hidden from the statisticians. But its problems are
due also to major structural weaknesses, especially of its institutions2; extreme political
polarisation; and reckless (for the lenders as well as borrowers) capital inflows that for
years disguised these underlying flaws. It is wrong to reduce these factors to inadequate
‘competitiveness’ that could be cured by currency devaluation.
Ireland’s woes arise from an extraordinary housing boom (incontestably a housing
price bubble) fed by equally reckless capital inflows through its banks into property
development and mortgage finance, lubricated by crony capitalism. The original sin
which has led Ireland to its penance was not, however, this process itself but rather the
government guarantee of the bank debts thereby incurred. In a stroke, this socialisation
of private debt transformed a country with one of the lowest ratios of public debt to
GDP into one with an exceptionally high debt ratio.
Spain too had its housing boom and capital inflow into construction. These were
exacerbated by the foolish behaviour of the politically influenced regional banks,
the cajas, which fell into deep difficulties when the bubble burst. Portugal has many
economic ills: poor education, an uncompetitive production structure, product and
labour market rigidities. But its primary mistake was not to use the very large capital
inflow during the pre-crisis decade to modernise the economy.
Three of these four countries (the GIPS) had sound fiscal positions but from 2003–04
onwards were running large current-account deficits within the monetary union; Greece
also had a big current-account deficit. These were financed by equally large capital
flows from the surplus countries, especially Germany – a capital flow ‘bonanza’3 for
the periphery, with the usual consequences. In particular, much of the funds went into
real-estate purchase and development. This raised the relative price of non-traded goods
and pulled resources out of tradeables. The Eurozone as a whole ran a balanced current
2 Jacobides et al (2011).3 Reinhart and Reinhart (2008).
Rethinking Global Economic Governance in Light of the Crisis
38
account with the rest of the world – the imbalances were internal. Germany played the
same role in the Eurozone as China in the global economy. Unlike the United States,
however, the GIPS were not ‘free spenders’ – Ireland and Spain had housing booms,
but they and Greece all saw a fall in consumption as a share of GDP and a rise in the
investment share during 2000–07 (the investment share fell slightly in Portugal). And
unlike China, the capital flows from Germany (and some other countries, like France)
came primarily from banks – they were private not official flows.
Correspondingly, the macroeconomic problem in EMU now is the fiscal consequence
of the financial crisis in bank-based financial systems. Creditor countries have been
unwilling to let their banks suffer the consequences of bad loans – rather, they have
managed to put the entire burden on the taxpayers of the debtor countries. This may
seem clever, but it is short-sighted, not to say hypocritical. It also disregards the EU and
Eurozone financial integration that policymakers have promoted – using an American
analogy, should Delaware, where Citibank is incorporated, be responsible for Citibank’s
liabilities?
The result is that Greece is insolvent, Ireland’s debt is also excessive and should be
restructured4, and Portugal’s IMF programme is not feasible. Spain and Italy, however,
are solvent, if financial markets return to normal conditions and both countries carry
out appropriate macroeconomic and structural policies. But Italy and Spain are under
pressure from the markets. They fear that Spanish banks will suffer further from bad
real-estate loans, and the state will have to bail them out. Italian political instability
and irresolution has reinforced contagion from the weaker countries, and Italy too may
enter a self-fulfilling vicious spiral: rising debt-service costs hurt the fiscal position
(Italy is close to primary fiscal balance), that hits market confidence, spreads rise, and
debt service begins to look unsustainable despite the primary balance. The markets
have also been losing confidence in French banks, despite the protestations of health
from the banks and their regulators; this has now calmed, but that may be temporary.
4 Portes (2011).
The Eurozone crisis – April 2012
39
Common to all these cases is an interconnected sovereign and banking crisis: the banks
hold large amounts of sovereign debt that has become questionable, and the sovereigns
are questioned because of the danger that they will have to rescue their banks.
So we have the ‘doom loops’ represented in this useful diagram5 and exacerbated by
elements of Fisherian debt deflation:
Figure 1. The European Peripherals Crisis
Higher Government Bond Yields
Higher Government Debt/GDP Ratio
Deeper Recession
More Banking/ Financial Strains
Bank Solvency Concerns
Calls for Fiscal TighteningNegative
Wealth E�ect
Reduced Loan
Supply
Lower Nominal GDP
Default Worries
Higher Debt Service
Bailout Costs
Lower Corporate
Pro�ts
Credit Losses
Lower Tax Receipts
TighterFCI
The euro (monetary union) is not the cause of this crisis, although the ECB’s
interpretation of its role has been blocking a solution. The ECB has been ‘in denial’,
maintaining as late as May 2011 that it was inconceivable that a Eurozone country
5 Goldman Sachs (2011) Global Economics Weekly 11/38, November.
Rethinking Global Economic Governance in Light of the Crisis
40
could default on its debt. The agreement of 21 July 2011 to restructure Greek debt
was, of course, recognition of default, regardless of whether the restructuring would
be ‘voluntary’ or not. The ECB told Ireland in autumn 2008 (backed by the threat of
withdrawal of repo facilities) that it was not allowed to consider debt default. Where
else in the world can a central bank tell a government what it can or cannot do in fiscal
matters?
Politicians share responsibility, however, with their indecision and endlessly repeated
‘too little, too late’ measures – such as the agreement of 21 July 2011, which was
recognised only three months later to be wholly inadequate. Moreover, the French
President and German Chancellor have made two egregious errors with disastrous
impact on the markets: the Deauville statement of October 2010 that introduced in
an ill-considered manner the possibility of private sector involvement in dealing with
Eurozone country debt; and the Cannes statement a year later that explicitly proposed
that an EMU member country could exit the euro. There is no legal basis for this6, and
it had been regarded as a taboo. Some have drawn an analogy with the statement by
the President of the Bundesbank in early September 1992 that “devaluations cannot be
ruled out” in the EMS – which was followed immediately by the exit of Italy and the
UK.
Several ways out have been proposed. If the banks’ capital is inadequate, then they
should be recapitalised. But with what external funding, if government participation is
excluded? Part of the problem is that the markets have been denying even short-term
funding to the banks. Consequently, the banks are deleveraging by selling assets and
not rolling over loans, with dangerous consequences worldwide. At one point, there
was talk of expanding or ‘leveraging’ the EFSF. But non-euro countries would not
contribute, leveraging through borrowing from the ECB is not allowed, and Eurozone
countries simply do not want to put up more funds.
6 See W Munchau (2012), Financial Times, 9 April.
The Eurozone crisis – April 2012
41
The extreme way out is to get out: might an exit of Greece from the Eurozone end the
instability? No, for it would immediately lead to devastating bank runs in all countries
that might conceivably be thought candidates to follow Greece. What firm or household
in Portugal, Ireland, Spain, Cyprus, would not seek to avoid even a low probability
that its bank deposits might be devalued overnight? The likely outcome would be
multiple exits, quite possibly the breakup of the monetary union. And that would be
disastrous not only for the exiting ‘weak’ countries but also for those that would then
suffer massive exchange-rate appreciation and the economic dislocation consequent on
massive contract uncertainty. The various plans for exit or Eurozone breakup are all
deeply flawed.
The only stable solution, therefore, is for the ECB to accept explicitly, in some form,
the role of lender of last resort (LLR) for the monetary union. (One might alternatively
regard this as a form of quantitative easing.) This does come within the Maastricht
Treaty mandate:
In accordance with Article 105(1) of this Treaty, the primary objective
of the ESCB shall be to maintain price stability. Without prejudice to the
objective of price stability, it shall support the general economic policies in
the Community…
5. The ESCB shall contribute to the smooth conduct of policies pursued
by the competent authorities relating to the prudential supervision of credit
institutions and the stability of the financial system.
Treaty of Maastricht (1992), Article 2 and Protocols Art. 105.5 (numbering
changes in Lisbon Treaty, but no change in text)
It would not violate the ‘no bailout clause’ (which does, however, exclude ECB
purchases of Eurozone sovereign debt on the primary market). And in fact, the ECB
has been purchasing member state bonds on the secondary market since May 2010,
without any successful legal challenge.
Rethinking Global Economic Governance in Light of the Crisis
42
To stop self-fulfilling confidence crises, therefore, the ECB should commit to cap yields
paid by solvent countries with unlimited purchases in the secondary markets. Arbitrage
will then bring primary issue yields down to the capped level. Note ‘solvent’: the then
Governor of the Bundesbank was right to oppose such purchases for Greece in May
2010, because it was evidently insolvent.
There is no more inflation risk in such a policy than there is in quantitative easing –
and that risk is negligible, as shown by the examples of the US, the UK, and Japan.
The ECB can always tighten as and when necessary. The risk preoccupying the ECB
is that of moral hazard: it clearly views ‘market discipline’ as the only way to bring
about the macroeconomic policies it favours. The evidence? Berlusconi’s departure and
replacement by Monti; and a technocratic government in Greece led by the former
ECB Vice-President, willing to accept the harsh austerity policies demanded by the
IMF-ECB-EC troika. Financial market pressures have been consciously used to drive
governments to implement austerity and reforms.
Thus the ECB does only ad hoc government debt purchases under its Secondary Market
Programme, in the guise of ‘normalising the monetary transmission mechanism’ that is
impaired by debt-market instability. Even those have ceased, for the time being. This is
a version of the ‘constructive ambiguity’ beloved of central bankers – but in this case,
it is manifestly destructive rather than constructive. The piecemeal approach, acting
only under pressure and with delay, has proved very costly. In effect, the ECB has
been playing a game of ‘chicken’ with the politicians and the markets. It is particularly
dangerous both because there are three players, of which two have no single decision-
maker; and because the parameters defining the game are not well defined, since no one
can tell when a vicious spiral may turn into an overwhelming confidence crisis that the
authorities will be unable to control.
On the other hand, the ECB does need political backing to take on the LLR role overtly.
The German and French leaders would have to make the case that this is the only
way to preserve the monetary union. And the ECB would also need to receive explicit
The Eurozone crisis – April 2012
43
indemnities (guarantees) from Finance Ministers of the 17 against capital losses the
bank might incur on its sovereign bond purchases. Both the US Federal Reserve and the
Bank of England have received such indemnities in respect of their quantitative easing
programmes.
When that guarantee has been secured, the ECB should make an expectations-changing
announcement of the new policy, just as the Swiss National Bank did when it moved
to cap the value of the Swiss franc. As that example shows, it is highly likely that if the
commitment were made, the markets would recognise that betting against the bonds
(a speculative attack) could not succeed, because the ECB would then have unlimited
capacity to resist. Hence it would not have to buy much if at all.
Ideally, this short-run stabilising policy would be complemented by long-run plans
for fiscal stability and integration, as well as by the issue of Eurobonds (issued at the
Eurozone level with ‘joint and several liability’). That would establish the kind of
‘convergence play’ that drove the markets smoothly into EMU at the end of the 1990s.
There are several Eurobond proposals now on the table, but the leaders of the major
countries have so far rejected them.
Although the ECB policy proposed above could buy time for economic reforms to work,
long-run debt sustainability requires economic growth. But we should be clear: fiscal
contraction is contractionary7. The evidence accumulates daily, for the UK as well as for
Eurozone countries. The only counterexample is that of Ireland in the 1980s. But this is
a very special case: a rather backward country catching up to the technological frontier;
exporting into a boom in its major trading partners (especially the UK); creating an
exceptionally favourable environment for foreign direct investment; and exploiting a
well-educated diaspora willing to return.
The austerity policies championed by Germany and other apostles of fiscal rectitude,
implemented enthusiastically by the European Commission, are not the solution, but
7 Guajardo et al (2011)
Rethinking Global Economic Governance in Light of the Crisis
44
rather a major part of the problem. They are driving the Eurozone into a new recession.8
The debt of several Eurozone countries is not sustainable if they contract.
Moreover, fiscal contraction together with private-sector deleveraging is not feasible
without a current-account surplus. We teach this in first-year macroeconomics:
CA = (Sp – I
p) + (T – G)
The current account must equal the sum of private-sector net saving and government
net saving. In the Eurozone, the surplus countries are those with the most ‘fiscal
space’. There will be no exit from the current debt traps and stagnation unless the
surplus countries are willing to accept that they must allow the others to expand. This
requires that they either relax their fiscal policy or adopt other policies that will reduce
private net savings. The overall position would improve if the euro were to depreciate
significantly – another reason for further monetary easing. But that is true for the US
and Japan as well.9
The LTRO was an inspired move to bypass German objections to the ECB taking on the
LLR role. But it is a temporary expedient. There is no evident exit strategy, even though
the President of the Bundesbank is calling for exit much sooner than the specified three-
year horizon. Moreover, channelling funding to the banks and relying on them to buy
sovereign bonds simply raises the weight of those bonds in their assets and worsens the
unhealthy interdependence between banks and sovereigns.10 And it reduces the pressure
on the banks to rationalise their portfolios and improve their business models.
Germany and France have benefited greatly from the single currency over its first
decade. Their business communities see this. One must still hope that the core Eurozone
countries will eventually act in their own best interests. The global financial crisis need
8 See http://eurocoin.cepr.org/ , where the Eurocoin coincident indicator has been firmly in negative territory over the past several months.
9 This is not to say that ‘competitive quantitative easing’ at the zero lower bound for interest rates will be ineffective or ‘beggar-thy-neighbour’ policies – see Portes (2012).
10 See De Grauwe (2012) and Wyplosz (2012).
The Eurozone crisis – April 2012
45
not lead to the demise of the single currency through a Eurozone crisis. This crisis could
be resolved successfully if policymakers were to change course.
References
De Grauwe, P (2012), “How not to be a lender of last resort”, CEPS Commentary 23
March.
Goldman Sachs (2011), Global Economics Weekly 11/38, November.
Guajardo, J, D Leigh, and A Pescatori (2011) “Expansionary austerity: new international
evidence”, IMF Working Paper 11/158.
Jacobides, M, R Portes, and D Vayanos (2011), “Greece: the way forward”, White
Paper, 27 October, summarised at www.VoxEU.org, 30 November.
W Munchau (2012), Financial Times, 9 April.
Palladini, G, and R Portes (2011), “Sovereign CDS and bond pricing dynamics in the
Eurozone”, CEPR Discussion Paper 8651, NBER Working Paper 17586, November.
Portes, R (2010), “Ban naked CDS”, at www.eurointelligence.com, 18 March.
Portes, R (2011), “Restructure Ireland’s debt”, www.VoxEU.org, 26 April.
Portes, R (2012), “Monetary policies and exchange rates at the zero lower bound”,
Journal of Money Credit and Banking, forthcoming.
Reinhart, C, and V Reinhart (2008), “Capital flow bonanzas”, CEPR Discussion Paper
6996, October.
Wyplosz, C (2012), ‘The ECB’s trillion-euro bet’, VoxEU.org 13 February
Rethinking Global Economic Governance in Light of the Crisis
46
About the author
Richard Portes, Professor of Economics at London Business School, is Founder and
President of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes at
the Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairman
of the Board of Economic Policy. He is a Fellow of the Econometric Society and of
the British Academy. He is a member of the Group of Economic Policy Advisers to
the President of the European Commission, of the Steering Committee of the Euro50
Group, and of the Bellagio Group on the International Economy. Professor Portes was a
Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,
Harvard, and Birkbeck College (University of London). He has been Distinguished
Global Visiting Professor at the Haas Business School, University of California,
Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia
Business School. His current research interests include international macroeconomics,
international finance, European bond markets and European integration. He has written
extensively on globalisation, sovereign borrowing and debt, European monetary issues,
European financial markets, international capital flows, centrally planned economies
and transition, macroeconomic disequilibrium, and European integration.
47
Explanations of the breakdown of the Bretton Woods exchange-rate system often
refer to the Triffin Dilemma. Recently, proposals for a multipolar reserve system have
invoked a supposed new form of the Triffin Dilemma (Farhi et al 2011), as a reason for
moving towards a multipolar reserve system. But the Triffin Dilemma did not describe
the problems of the international monetary system in the late 1960s, and it does not
describe the present-day problems of that system. The world will move towards a
multipolar reserve system, but for reasons unrelated to the Triffin Dilemma.
1 Triffin Dilemma definitions
There are at least two rather different formulations of the Triffin Dilemma in recent
discussions. The definition that is perhaps closer to what Triffin had in mind is that
increasing demand for reserve assets strains the ability of the issuer to supply sufficient
amounts while still credibly guaranteeing or stabilising the asset’s value in terms of an
acceptable numéraire (see Obstfeld 2011 as well as Farhi et al 2011). An alternative
perspective from a policymaker is that the dilemma is founded on a tension between
short-run policy incentives in reserve-issuing and reserve-holding countries, on the one
hand, and the long-run stability of the international financial system on the other hand
(Bini Smaghi 2011).
Richard PortesLondon Business School and CEPR
The Triffin Dilemma and a multipolar international reserve system
Rethinking Global Economic Governance in Light of the Crisis
48
2 The Triffin Dilemma of the 1960s
A dilemma is a difficult choice between alternatives. The first posited that the US
would stop providing more dollar balances for international finance. In that case, trade
would stagnate and there would be a deflationary bias in the global economy – a global
liquidity shortage. The second was that the United States would continue to provide
more of the international reserve currency, leading ultimately to a loss of confidence in
the dollar, as US obligations to ‘redeem’ foreign holdings with gold would be seen to
be unsustainable.
Some writers have identified the second alternative with continued US current-account
deficits. But this is not correct, either empirically or conceptually.
3 Another interpretation of the 1960s
The US current account was actually in surplus throughout the 1960s. Moreover, much
of the growth of dollar reserves from 1955 onwards was driven by foreign demand for
money (recall the ‘dollar shortage’ of the late 1940s and early 1950s) and posed no
threat to US liquidity (Obstfeld 1993).
One analysis at the time took a different line (Despres et al 1966) – a ‘minority view’,
as the authors put it. They argued that the US ‘deficit’ arose from its role as the world
banker (see also Gourinchas and Rey 2007). It borrowed short (issuing riskless assets)
and lent long (buying risky assets). The source of the dollar balances accumulated
abroad was net capital outflows, not current-account deficits.
More generally, “current accounts tell us little about the role a country plays in
international borrowing, lending, and financial intermediation…” (Borio and Disyatat
2011). Moreover, Despres et al argued that the key issue was not external (global)
liquidity but rather internal liquidity in Europe. That is, the United States was supplying
financial intermediation to a Europe whose financial system was still incapable
of providing that intermediation itself. The lack of ‘confidence’, they suggested,
The Triffin Dilemma and a multipolar international reserve system
49
reflected a failure to understand this intermediary role. Hence, they argued, there was
a straightforward policy response: develop and integrate foreign capital markets, while
seeking to moderate foreign asset holders’ insistence on liquidity. This minority view
of 1966 was the correct one. It was put forward in the same year in which Valery
Giscard d’Estaing spoke of the ‘exorbitant privilege’. It resonates with today’s policy
discussions of global imbalances (Portes 2009).
In sum, the ‘dollar problem’ of the 1960s was not founded on the Triffin Dilemma.
Rather, it was simply a result of the US inability to convince dollar holders that the
US would maintain a stable value of the dollar with appropriate monetary and fiscal
policies. If the US had done that, then dollar holders would have had no incentive to
demand gold (Obstfeld 1993) – unless it were to destroy the exorbitant privilege, as
perhaps was the main French objective.
4 Is there a Triffin Dilemma now?
The leading current version of the Triffin Dilemma starts from the hypothesis that the
global economy faces a chronic, severe shortage of reserve assets, which are identified
with ‘safe assets’ (Caballero 2006). The empirical evidence cited for this shortage is the
persistently low level of real interest rates.
There are several formulations of the problem which is supposed to be raised by
the assumed shortage of safe assets. First, excess demand for safe assets leads to a
deterioration of the creditworthiness of the safe asset pool – leading up to the 2008
financial crisis, we saw a wide range of assets rated at AAA that subsequently were
revealed as very unsafe indeed.
Second, the supply of truly safe dollar assets – US Treasuries – rests on the backing of
the US ‘fiscal capacity’. But that grows only as US GDP grows, and US GDP grows
slower than world GDP, which determines the growth of demand for those assets.
Hence there must be a growing excess demand for safe assets.
Rethinking Global Economic Governance in Light of the Crisis
50
Third, it is the “ability to provide liquidity in times of global economic stress [that]
defines the issuer of the reserve currency” (Farhi et al 2011). This again rests on US
fiscal capacity.
Fourth, global reserve growth requires an ongoing issuance of gross US government
debt, which requires either fiscal deficits or issuing debt to buy riskier assets. Global
reserve growth is therefore driven by fiscal deficits, not balance-of-payments deficits,
and the resulting government debt will eventually outrun US fiscal capacity.
Farhi et al do not define fiscal capacity, but they seem to mean the sustainability
of government domestic debt or the solvency of a government. What debt level is
‘sustainable’ is a matter of considerable controversy, whether it applies to domestic
or international debt (eg, Mendoza and Ostry 2008, Alogoskoufis et al 1991), and it is
not straightforward to make the intertemporal budget constraint operational in order
to investigate this. In the sovereign debt and default literature, these are old issues,
concerning the difficulties of distinguishing for a sovereign ‘can’t pay’ from ‘won’t
pay’ or illiquidity from insolvency.
Moreover, even setting these problems aside, the empirical evidence for this version of
the Triffin Dilemma seems weak. We see no global liquidity shortage, no deflationary
bias from that source. Even during the financial crisis of 2008–09, the only manifestation
of inadequate global liquidity (as opposed to particular securities markets) was a short-
run lack of dollars to finance dollar positions. This was met by short-term currency
swaps, which briefly rose to high levels but were quickly wound down.
The main evidence cited for the shortage of safe assets is low real interest rates. It is
indeed correct that real interest rates fell steadily from the 1980s and early 1990s to
levels that seemed historically low in the 2000s. But they were not historically low –
real interest rates were lower in the 1960s and 1970s (the average real interest rate on
the sovereign borrowing of the 1970s was significantly negative). Are we supposed to
believe that there was a shortage of safe assets both pre- and post-1971? Finally, the US
is not the only source of safe assets – the government bonds of Germany, the United
The Triffin Dilemma and a multipolar international reserve system
51
Kingdom, Norway, and Switzerland are also held in substantial amounts by foreign
investors. A further critique of the ‘safe asset shortage view’ can be found in Borio and
Disyatat (2011).
Suppose the US had maintained the fiscal balance it achieved in 1999–2000. The net
supply of US Treasuries was stable or falling, but private investment exceeded savings,
so there was a current-account deficit, with a rising foreign demand for reserves.
What would the foreigners have bought? If the dominant source of safe assets was US
Treasuries, then the constraint on the supply of these (reserve) assets would not have
been US fiscal capacity, but US fiscal rectitude – no Triffin Dilemma, as set out by
Farhi et al.
And finally, note that it is not clear that the US current-account deficits of the 2000s
were due to a demand for additional reserve assets from the rest of the world. That
demand could have been met by net private capital outflows, as in the 1960s.
5 The policy implications
The world will move towards a multipolar reserve system. But this will happen not
because of the Triffin Dilemma and a shortage of safe assets in the current dollar-
dominated system. It will happen because official reserve holders want to diversify
their portfolios. (See Papaioannou et al 2006). And the correction of global imbalances
will promote this.
For policymakers, the message is to try to convince surplus countries that reserve assets
are not as safe as they think, so that they reduce their demand for these assets (China
has already suffered a large capital loss because of dollar depreciation in the 2000s).
The asymmetry between pressures on surplus and on deficit countries might be met by
doing the opposite of creating more ‘safe assets’ – that is, by raising the risk premium
on the supposedly safe assets, so that countries accumulating reserves cut their demand
for them, shifting their portfolios towards other assets (for example sovereign wealth
Rethinking Global Economic Governance in Light of the Crisis
52
funds). (Goodhart 2011 appears to be advocating policies that would have this effect.)
Such a trend could accelerate if the dollar were to continue to depreciate.
As the world moves towards a multipolar reserve system, emerging market countries will
develop their domestic financial markets and will have less need for foreign financial
intermediation (cf. Despres et al). Some emerging-market countries may themselves
become reserve suppliers. And the development of more international facilities centred
on the IMF could reduce the demand for reserves for self-insurance (Farhi et al).
Considering the Triffin Dilemma undoubtedly helps us to understand the forces
underlying the development of the international financial system. But it is not the
source of the system’s present-day problems.
Author’s note: This essay is based on my contribution to the conference “The
International Monetary System: sustainability and reform proposals” held in Brussels
on 3–4 October 2011, to commemorate the 100th anniversary of the birth of Robert
Triffin. I am grateful for comments from Maurice Obstfeld. I am also indebted to
Tommaso Padoa Schioppa for many discussions of these issues over 25 years and to
Hélène Rey for more recent extended discussions – even though, in both cases, we
sometimes had to agree to disagree, as will be evident from the text.
The Triffin Dilemma and a multipolar international reserve system
53
References
Alogoskoufis, G, L Papademos, and R Portes (1991), External Constraints on
Macroeconomic Policy, Cambridge: Cambridge University Press for CEPR.
Bini Smaghi, L (2011),” The Triffin Dilemma revisited”, 3 October, at http://www.ecb.
int/press/key/date/2011/html/sp111003.en.html, and in this volume.
Borio, C, and P Disyatat (2011), “Global imbalances and the financial crisis: Link or no
link?”, BIS Working Paper 346.
Caballero, R (2006), “On the macroeconomics of asset shortages”, NBER Working
Paper 12753.
Despres, E, C Kindleberger, and W Salant (1966), “The dollar and world liquidity: a
minority view”, The Economist, 6 February.
Farhi, E, P-O Gourinchas, and H Rey (2011), Reforming the International Monetary
System, CEPR eBook, French version published by Conseil d’Analyse Economique.
Goodhart, C A E (2011), “Global macroeconomic and financial supervision: where
next?”, paper for Bank of England–NBER conference.
Gourinchas, P-O, and H Rey (2007), “From world banker to world venture capitalist:
the US external adjustment and the exorbitant privilege”, in Clarida, R (ed), G7 Current
Account Imbalances: Sustainability and Adjustment, Chicago: University of Chicago
Press for NBER.
Mendoza, E, and J Ostry (2008), “International evidence on fiscal solvency: Is fiscal
policy ‘responsible’?”, Journal of Monetary Economics 55: 1081–93.
Obstfeld, M (1993), “The adjustment mechanism”, in Bordo, M, and B Eichengreen
(eds), A Retrospective on the Bretton Woods System, Chicago: University of Chicago
Press for NBER.
Rethinking Global Economic Governance in Light of the Crisis
54
Obstfeld, M (2011), “The international monetary system: living with asymmetry”,
forthcoming in Feenstra, R C and A M Taylor (eds), Globalization in an Age of Crisis:
Multilateral Economic Cooperation in the Twenty-First Century.
Papaioannou, E, R Portes, and G Siourounis (2006), “Optimal Currency Shares in
International Reserves: The Impact of the Euro and the Prospects for the Dollar”,
Journal of the Japanese and International Economies 20: 508–47.
Portes, R (2009), “Global imbalances”, in Dewatripont, M, X Freixas and R Portes
(eds), Macroeconomic Stability and Financial Regulation, London: Centre for
Economic Policy Research.
The Triffin Dilemma and a multipolar international reserve system
55
About the author
Richard Portes, Professor of Economics at London Business School, is Founder and
President of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes at
the Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairman
of the Board of Economic Policy. He is a Fellow of the Econometric Society and of
the British Academy. He is a member of the Group of Economic Policy Advisers to
the President of the European Commission, of the Steering Committee of the Euro50
Group, and of the Bellagio Group on the International Economy. Professor Portes was a
Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,
Harvard, and Birkbeck College (University of London). He has been Distinguished
Global Visiting Professor at the Haas Business School, University of California,
Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia
Business School. His current research interests include international macroeconomics,
international finance, European bond markets and European integration. He has written
extensively on globalisation, sovereign borrowing and debt, European monetary issues,
European financial markets, international capital flows, centrally planned economies
and transition, macroeconomic disequilibrium, and European integration.
57
The global crisis which has been ricocheting around the global economy since late
2007 seems to have undermined, perhaps even destroyed, the traditional foundations
for financial stability in the US and Europe. This chapter focuses on recommendations
for the provision of financial stability, and in doing so builds some bridges between two
of the PEGGED themes – financial stability and macroeconomic governance. There
are three essential points to be drawn from the range of research findings from the
PEGGED political economy team:
• The policy dilemmas and choices confronted by the contemporary system of global/
EU financial and monetary governance are longstanding, well-known, and there is a
host of historical experience and literature to draw upon going forward.
• The potential and more obvious flaws of the pre-crisis system of financial govern-
ance were well-known and debated in the many rounds of reform that preceded
the financial collapse. Our analysis reveals that the ideas upon which the reforms
have been built remain largely stuck in the pre-crisis mode and are thus unlikely to
achieve their goals. Worse, the Eurozone is descending into modes of crisis reso-
lution that are known to be dysfunctional and destructive of successful economic
growth and development.
• Reform that is more likely to provide financial stability for the longer run requires
new ideational departures drawing on established historical experience, consider-
able institutional innovation, a reformed policy process, and institutionalised at-
tention to the political legitimacy and long-run sustainability of financial openness
globally and in the EU.
Geoffery UnderhillUniversity of Amsterdam
Financial stability: Where it went and from whence it might return
Rethinking Global Economic Governance in Light of the Crisis
58
The points are developed more fully in turn.
Financial openness: Beneficial but inherently instability
Historical experience has shown that financial liberalisation and market integration
produce benefits, if asymmetric. Theory (Minsky 1982) and historical experience
(Bordo et al. 2001) told us financial markets had a strong tendency towards instability
and crisis. Avoiding persistent market failure requires robust systems of governance at
the level appropriate to the extent of market integration.
This implies regional and international institution-building. The dilemmas of such
institutional design and the appropriate policy mix have been well-known since the
1920s at least (Germain 2010), and certainly since the Bretton Woods conference.
Despite this knowledge and the frequency of episodes of financial crisis in the 30 years of
liberalisation from the 1980s on, a crisis-reform-crisis cycle only led to the complacency
of the Great Moderation (Helleiner 2010). Financial globalisation was furthermore
known to be particularly problematic for developing countries (Cassimon et al, 2010,
and Ocampo and Griffith-Jones 2010). The institutional and economic weaknesses of
the European monetary union were likewise well-known and exhaustively discussed in
the literature (Underhill 2011a).
Systemic flaws known before the crisis
Our system of debt-crisis workout has long pointed the finger at debtors. IMF
programmes available to debtors seeking to avoid default to public and private creditors
involved a combination of emergency loans, enhancing the debt burden, and structural
adjustment measures. These latter often come with substantial distributional costs for
the borrowing nation, often its poorest citizens. There is substantial evidence that these
programmes have too often failed to stimulate economic recovery and growth (Vreeland
2003). The argument that structural adjustment leads to a ‘catalytic’ restoration of
private investor confidence likewise does not appear to hold (de Jong and van de Veer
Financial stability: Where it went and from whence it might return
59
2010). The Argentine default in 2001-2 saw the country emerge from crisis as well or
better than orthodox Brazil, which took the full ‘medicine’ (Klagsbrunn 2010).
The system of international banking supervision was equally flawed. The first effort
– from the Market Risk Amendment to Basle I in 1996 through to the finalisation of
Basle II in 2004 – relied on self-supervision by large banks. The key tool was internal
risk assessment and attendant controls. In essence, it was a micro approach to risk
management based on market price signals, risk ratings and weightings, and a range of
financial ‘governance’ standards.
This market-based approach to the financial sector, or “governance light”, was amply
criticised as procyclical and dangerous (Persaud 2000, Ocampo and Griffith-Jones),
and it neglected the macroprudential dimensions of systemic risk (Claessens and
Underhill 2010). The system furthermore provided direct competitive advantages to the
same large-bank constituency that had proposed the idea in the first place. Moreover, it
involved a substantial rise in the cost of capital for poor countries and their populations
who had no access to the decision-making forum (Claessens et al. 2008).
The theories and argument pools from which the new policies were drawn became
tilted towards particularistic interests; state officials and the private sector came to share
interests and approaches to governance in a club-like setting (Tsingou 2012). There was
a serious policy rent-seeking and capture problem in the financial policy community
– the input side of the policy process was flawed (Claessens and Underhill) and idea-
sets on stability of the market skewed as result (Baker 2010). As a result, regulation
backfired. Policies adopted to secure financial stability were those least likely to
achieve it! Rather, they provided material advantages to the large financial institutions
that benefited most from financial liberalisation in the first place.
So the 30 years of global financial integration lurched from crisis to skewed reform
to crisis once again. Much of the burden of reform was on the emerging markets and
developing countries that experienced crises most frequently. Their experience led
them, particularly after the Asian crisis, to question the market-based approach to
Rethinking Global Economic Governance in Light of the Crisis
60
financial governance and to choose a different path. Most took liberalisation seriously,
implementing reforms in their own way (Zhang 2010; Walter 2010) often while
introducing innovative forms of capital controls aimed at ensuring greater stability.
Asian countries began to go their own regional way in terms of regional cooperation
(Dieter 2010). In the end, only the emerging market countries genuinely rose to the
challenge of reform, avoiding the recipe of the advanced financial centres and largely
avoiding the global financial crisis of 2007-9 as a result.
Financial Stability: From whence might it return?
Despite proposed improvements in the level and quality of capital required of large
banks, the underlying market-based approach to financial governance and supervision
has not changed (Underhill 2012). There are still many reforms in the pipeline, but if
they are to be enduring and successful, new policy idea-sets must be developed.
The most innovative turn in the reform process is towards a macroprudential approach
aimed at better management of the systemic dimensions of risk. Yet it is not at all clear
that there is yet a coherent set of ideas, least of all concrete measures. Successfully
operationalising macroprudential oversight requires institutional innovations across
national and international levels to “join the dots” among policy domains. Until now,
such domains have been treated all too separately, for example:
• Global imbalances and macroeconomic adjustment.
• Monetary policy in relation to asset markets.
• Multilateral surveillance mechanisms.
• Debt loads (public and private).
• Financial system monitoring.
• Firm-level risk management.
Financial stability: Where it went and from whence it might return
61
This requires a more integrated institutional setting for policymaking and implementation.
Linked to the issue of macroprudential oversight, there is little sign of a much-needed
debt-workout regime in either the Eurozone or the global financial system.
New ideas are unlikely as long as there is no substantial shift on the input side of the
policy process.
• A broader range of stakeholders must become systematically involved in decision-
making if policy output is to change.
For instance, citizens whose pensions are at considerable risk should have a say
(Leijonhuvud 2011).
• Institutional change in the policy process could also provide insulation from the
threat of policy capture.
The interests of those who ultimately underwrite financial bailouts – the taxpayer –
must be far more robustly defended by public authorities.
• The sharing of responsibility and of the burden of adjustment imposed on debtors
versus creditors needs to be seriously rebalanced.
This is especially the case in the Eurozone, where the benefits of monetary union are
so skewed towards the surplus/creditor countries whose banks finance debt, both public
and private.
Yet this rethink is not happening. The Eurozone crisis is being managed under the
principle of IMF structural adjustment on steroids. Policy space is being dramatically
diminished, instead of being enhanced through the pooling of reserves and risks.
Why does this matter so much? The answer has to do with the long-run sustainability
and legitimacy of financial openness and capital mobility and whether we wish to have
continued access to the benefits it offers. The issue requires institutionalised attention
in a reformed policy process. Our research has shown that financial liberalisation is
better sustained in economies that mitigate the risks of liberalisation through welfare
Rethinking Global Economic Governance in Light of the Crisis
62
and other forms of compensation for the vulnerable (Burgoon et al. 2012). Centre-left
parties in stable democracies have often sponsored financial liberalisation traded off
against a functioning health care and welfare system. Developing countries that receive
compensation in the form of international aid flows also support financial openness
more readily. Nurturing these underpinnings of open finance requires the very policy
space that recession and austerity based workouts are closing down.
Meanwhile, electorates are rebelling against solutions that “pool” sovereignty just as
market integration makes national policy less effective. The risk is that failure to think
systematically about the emerging legitimacy deficit could lead to a rapid political
radicalisation.
Centrifugal populist political forces have already been generated by the process,
sometimes deliberately by politicians but more often by the nature of the solutions
developed. This context will continue to aggravate the difficulties of reaching workable
solutions to governing Eurozone or global finance and may call into question the
institutional and ideational plumbing of the system: the benefits of openness, the
autonomy of regulatory of agencies and central banks, and eventually the ability of
states to cooperate to reform financial governance.
In short, we need a financial system and Eurozone that not only saves banks, but also
citizens!
References
Baker, Andrew (2010). “Deliberative international financial governance and apex
policy forums: where we are and where we should be headed”, in G Underhill, J Blom
and D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to
Crisis, Cambridge University Press.
Bordo, M, B Eichengreen, D Klingebiel and M. Martinez-Peria (2001), “Is the crisis
problem growing more severe?” Economic Policy 16(32), 51-82.
Financial stability: Where it went and from whence it might return
63
Burgoon, B, P Demetriades and G Underhill (2012), “Sources and Legitimacy of
Financial Liberalisation,” European Journal of Political Economy 28(2), 147-161.
Cassimon, Danny, Panicos Demetriades and Björn Van Campenhout (2010).Finance,
globalisation and economic development: the role of institutions, in Global Financial
Integration Thirty Years On. From Reform to Crisis, Underhill, Blom and Mügge (eds.),
Cambridge University Press.
Claessens, S, G Underhill and X Zhang (2008), “The Political Economy of Basle II: the
costs for poor countries”, The World Economy 31(3), 313-344.
Claessens, Stijn and Geoffrey R. D. Underhill (2010). The political economy of Basel
II in the international financial architecture in G Underhill, J Blom and D Mügge (eds.)
Global Financial Integration Thirty Years On. From Reform to Crisis, Cambridge
University Press.
De Jong, Eelke and Koen van der Veer (2010). The catalytic approach to debt workout
in practice: coordination failure between the IMF, the Paris Club and official creditors,
in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty Years
On. From Reform to Crisis, Cambridge University Press.
Dieter, Heribert (2010). Monetary and financial co-operation in Asia: improving
legitimacy and effectiveness in G Underhill, J Blom and D Mügge (eds.) Global
Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University
Press.
Germain, R (2010), “Financial governance in historical perspective: lessons from the
1920s”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration Thirty
Years On. From Reform to Crisis, Cambridge University Press.
Helleiner, Eric and Stefano Pagliari (2010). “Between the storms: patterns in global
financial governance 2001–7”, in G Underhill, J Blom and D Mügge (eds.) Global
Rethinking Global Economic Governance in Light of the Crisis
64
Financial Integration Thirty Years On. From Reform to Crisis, Cambridge University
Press.
Klagsbrunn, Victor (2010), “Brazil and Argentina in the global financial system:
contrasting approaches to development and foreign debt”, in G Underhill, J Blom and
D Mügge (eds.) Global Financial Integration Thirty Years On. From Reform to Crisis,
Cambridge University Press.
Leijonhufvud, Axel (2011), “Shell game: Zero-interest policies as hidden subsidies to
bank”, VoxEU.org column, 25 January 2011.
Minsky, H (1982), “The Financial-Instability Hypothesis: Capitalist processes and the
behaviour of the economy,” in Kindleberger and Laffargue (eds.), Financial Crises:
theory, history, and policy, New York: Cambridge University Press.
Ocampo, José and Stephany Griffith-Jones (2010). “Combating procyclicality in
the international financial architecture: towards development-friendly financial
governance” in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration
Thirty Years On. From Reform to Crisis, Cambridge University Press.
Persaud, A. (2000), “Sending the Herd Off the Cliff Edge,” The Journal of Risk Finance
2(1), 59 –65.
Tsingou, E (2012), “Club Model Politics and Global Financial Governance: the case of
the Group of Thirty”, (unpublished PhD Thesis, University of Amsterdam).
Underhill, G. (2010), “Theory and the Market after the Crisis: the Endogeneity of
Financial Governance,” CEPR Discussion Paper CEPR-DP8164, December
Underhill, G. (2011) Reforming global finance: Coping better with the pitfalls of
financial innovation and market-based supervision, PEGGED Policy Paper, December
2011, available online at http://pegged.cepr.org/index.php?q=node/389.
Financial stability: Where it went and from whence it might return
65
Underhill, G. (2011a) “Paved with Good Intentions: Global Financial Integration, the
Eurozone, and the Hellish Road to the Fabled Gold Standard,” in D.H. Claes and C. H.
Knutsen (eds.), Governing the Global Economy: Politics, Institutions and Development,
Routledge , 110-130.
Underhill, G. (2012), The Emerging Post-Crisis Financial Architecture: the path-
dependency of ideational adverse selection,” Paper presented to the annual Joint
Sessions of the European Consortium for Political Research, University of Antwerp,
10-15 April.
Underhill, G and J Blom (2012), “The International financial Architecture: plus ca
change…,” in R Mayntz (ed.), Crisis and Control: Institutional change in Financial
Market Regulation, Campus Verlag/MPifG Social Science Series.
Underhill, G, J Blom and D Mügge (eds.) (2010), Global Financial Integration Thirty
Years On. From Reform to Crisis, Cambridge University Press.
Underhill, G and X Zhang (2008), “Setting the Rules: Private Power, Political
Underpinnings, and Legitimacy in Global Monetary and Financial Governance,”
International Affairs 84(3), 535-554.
Vreeland, James R (2003), The IMF and Economic Development, Cambridge University
Press.
Walter, Andrew (2010), “Assessing the Current Financial Architecture (How Well Does
it Work?”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration
Thirty Years On. From Reform to Crisis, Cambridge University Press.
Zhang, Xiaoke (2010), “Global markets, national alliances and financial transformations
in East Asia”, in G Underhill, J Blom and D Mügge (eds.) Global Financial Integration
Thirty Years On. From Reform to Crisis, Cambridge University Press.
Rethinking Global Economic Governance in Light of the Crisis
66
About the author
Geoffrey Underhill is Chair of International Governance is a political economist who
works closely and co-authors with economists and political scientists alike. He is a
specialist on the financial governance, macroeconomic adjustment and governance, and
international trade work packages, and will work with Burgoon on the issue of the
sustainability and legitimacy of (trade and financial) liberalisation.
67
Xavier FreixasUniversitat Pompeu Fabra and CEPR
The crisis and the future of the banking industry
The global economic crisis – which has been unfolding in various forms since the
subprime bubble burst in late 2007 – has come at a high social and economic cost. It
has also shattered confidence in US and European banking systems and questioned the
capacity of financial markets to channel resources to their best use.
After all, financial industry investments have proven ex post to be excessively risky
and the generally accepted view is that their risks were not ex ante sound. The list
of examples includes the subprime mortgages in the US and mortgages to markets
characterised by real estate bubbles in Europe.
The regulatory reforms that have taken place since the beginning of the crisis have
intended, among other objectives, to curtail this excessive appetite for risk. Yet, for
regulation to prevent future crises, one must know what caused the excessive risk-
taking in the first place.
What is excessive risk-taking?
To explore its causes, the first step is to give a more precise definition of ‘excessive
risk-taking’.1 One working definition of excessive risk-taking is a level of risk such that,
had it been known and taken into account ex ante by banks’ stakeholders, it would have
made the net present value of the bank’s investment project negative.
1 This draws heavily on the Introductory chapter in Dewatripont and Freixas (2012) written by the two editors.
Rethinking Global Economic Governance in Light of the Crisis
68
This view of ‘excessive risk-taking’ has the advantage of preserving the option for banks
to invest in high-risk ventures provided they result in a corresponding high return and
do not jeopardise the continuity of the bank as a going concern. It does not emphasise
financial institutions’ possibly overoptimistic expectations but rather the risk-adjusted
cost of funds, as well as the lack of transparency that characterises investment in banks:
lending to a financial institution on the basis of a reputation of safe investments in
the banking industry supported by a tradition of bailouts by the Treasury where even
uninsured debt holders have been protected from the bankruptcy losses.
With this definition in mind, four possible ‘culprits’ stand out:
• Managers’ incentives and corporate governance;
• Understatement of the business cycle risks (capital is excessively cheap and lending
excessively permissive in upturns with the opposite holding in downturns);
• Failure of regulatory supervision and market discipline to curb excesses in boom
times;
• Moral hazard, whereby banks take too much risk in anticipation of being bailed out
in the event of massive losses.
Findings and analysis
First of all, excessive risk-taking is directly related to corporate governance.2 The
decisions a bank takes regarding risk levels are ultimately the responsibility of managers
and boards of directors. Whether in their strategic decisions managers consider their
own bonuses, short-term stock price movements, shareholders’ short-run interests
(rather than stakeholders’ long-run ones) or simply the financial institution’s culture of
risk, these are all decisions that are substantiated by the board and therefore result from
the structure of financial institutions’ corporate governance.
2 For details, see Mehran et al (2012).
The crisis and the future of the banking industry
69
Mehran et al (2012) argue that corporate governance may be especially weak due to the
multiplicity of stakeholders (insured and uninsured depositors, the deposit insurance
company, bond holders, subordinate debt holders, and hybrid securities holders), and
the complexity of banks’ operations. Moreover the moral hazard created by the too-
big-to-fail situation may have led boards to encourage risk-taking as they knew that big
losses would be paid largely by taxpayers rather than stakeholders.
Second, the issue of excessive risk-taking may also be related to managers’ and
shareholders’ understatement of the business cycle risk of downturn, as the procyclicality
of capital may lead to excessive lending, the emergence of bubbles and a financial
accelerator effect.3 The fact that banks did not have enough capital once the crisis
unravelled is not only a failure of the Basel II regulatory framework and the models it
is based on, but also evidence of how critical the issue of procyclicality is for financial
stability. The regulatory proposal of Basel III on countercyclical buffers is intended
to solve this issue. Still, rigorous analysis of the procyclicality of banks’ capital may
indicate that the issue is more complicated than it seems.
Repullo and Saurina (2012) focus on one aspect of this, namely the question of whether
and how much additional capital should be required during excessive credit growth
phases, and how these excessive credit growth phases are to be identified. They study
how the Basel III regulatory framework proposes to tackle the issue and the extent to
which the rules accomplish their objectives.
The Basel III countercyclical provisions require higher capital-loan ratios when the
credit-to-GDP ratio deviates from its trend. Their analysis, however, shows this works
the wrong way for a majority of nations; the deviations are negatively correlated with
GDP growth. In short, banks that follow the deviation from trend rule may actually be
pursuing a procyclical rather than a countercyclic capital policy. The authors propose a
simpler rule – the credit growth rate.
3 For details, see Repullo and Saurina (2012).
Rethinking Global Economic Governance in Light of the Crisis
70
Third, it may be argued that the curtailing of excessive risk-taking was the joint
responsibility of supervision and market discipline, and that neither did a proper job.4
Theoretically both firms and gatekeepers are supposed to provide accurate information
to the market and to supervisory agencies. This information transmission issue has been
a key one in the analysis of the crisis, as it has been argued that it was the opacity of
some of the structured products, asset-backed securities, collateralised debt obligations,
and so on, that was in part responsible for the first stages of the crisis. It has also been
stated that the use of fair-value accounting by banks aggravated the crisis. So it is
clearly important to assess to what extent these claims are valid.
The market’s main sources of information are firms’ financial reports and credit rating
agencies. Freixas and Laux (2012) address a number of reproaches levelled at these
sources. On the financial reporting, the use of fair-value analysis has come in for strong
criticisms as it caused firms to write down asset falls as the markets collapsed, with this
leading to eroded capital and heightened uncertainty. The authors, however, argue that
fair value is not much to blame as it only affects banks’ trading portfolios and there is
substantial discretion for banks to suspend it if the losses are considered temporary.
They are more critical when it comes to credit rating agencies, concluding that these
profit-maximising firms are in an institutional setting that inadequately deals with
conflicts of interests. They call for more regulation of credit rating agencies to redress
this.
Fourth, excessive risk-taking may be the result of another form of market discipline
if all banks in distress are to be bailed out.5 This would, of course, be taken into
account by a bank’s managers and board of directors and completely distort the bank’s
decision since, in this case, bankruptcy threats are no longer credible. Consequently,
how regulatory agencies and Treasuries organise banks’ resolutions will determine
future moral hazard. It is therefore worth considering how a bank in distress can be
4 Freixas and Laux (2012).5 Freixas and Dewatripont (2012).
The crisis and the future of the banking industry
71
restructured in an orderly way, whether it is to be closed or bailed out in such a way as
to preserve banks’ incentives and be credible while limiting contagion to other banks.
Freixas and Dewatripont (2012) argue that the first objective of regulation is therefore
to reduce the cost of bankruptcies; this is the main focus of the last chapter. Banking
resolution should be thought of as a bargaining game between shareholders and
regulators. Shareholders want to maximise the value of their shares while regulatory
authorities’ main objective is to preserve financial stability at the lowest possible cost.
Given this, time plays against the regulatory authority. The authors thus argue for
bankruptcy rules that are specially crafted for the banking sector (and different from
those applying to non-financial corporations).
In this game, time is of the essence – even with the perfectly efficient bankruptcy
procedure. Banks in distress should be quickly closed or quickly bailed out. The
chapter’s examination of banking crises in different countries shows great variety in
the procedures followed and concludes that theory has no clear-cut recommendations
to offer.
Plainly the design of the bank resolution mechanisms is critical. One proposal is to add
a layer of capital to prevent future crises, but the authors defend the possibilities opened
by contingent capital and by bail-ins. They argue that these types of mechanisms would
preserve the best characteristics of debt and therefore limit moral hazard. The authors
conclude by considering cross-country resolution and the challenges it implies and
discuss the recent changes in the European banking resolution framework.
References
Dewatripont, M and X Freixas, eds (2012), The Crisis Aftermath: New Regulatory
Paradigms, London: Centre for Economic Policy Research.
Rethinking Global Economic Governance in Light of the Crisis
72
Mehran, H, A Morrison and J Shapiro (2012). “Corporate Governance and Banks: What
Have We Learned from the Financial Crisis?”, in Dewatripont, M and X Freixas (eds),
The Crisis Aftermath: New Regulatory Paradigms, London: CEPR.
Repullo, R and J Saurina (2010), “The Countercyclical Capital Buffer of Basel III: A
Critical Assessment”, in Dewatripont, M and X Freixas (eds), The Crisis Aftermath:
New Regulatory Paradigms, London: CEPR.
Freixas, X and C Laux (2012), Disclosure, Transparency and Market Discipline”, in
Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms,
London: CEPR.
Dewatripont, M and X Freixas (2012), “Bank Resolution: Lessons from the Crisis” in
Dewatripont, M and X Freixas (eds), The Crisis Aftermath: New Regulatory Paradigms,
London: CEPR.
The crisis and the future of the banking industry
73
About the author
Xavier Freixas (Ph D. Toulouse 1978) is Professor at the Universitat Pompeu Fabra
in Barcelona (Spain) and Research Fellow at CEPR. He is also Chairman of the Risk
Based Regulation Program of the Global Association of Risk Professionals (GARP).
He is past president of the European Finance Association and has previously been
Deutsche Bank Professor of European Financial Integration at Oxford University,
Houblon Norman Senior Fellow of the Bank of England and Joint Executive Director
Fundación de Estudios de Economía Aplicada FEDEA), 1989-1991, Professor at
Montpellier and Toulouse Universities.
He has published a number of papers in the main economic and finance journals
(Journal of Financial Economics, Review of Financial Studies, Econometrica, Journal
of Political Economy,…).
He has been a consultant for the European Investment Bank, the New York Fed, the
ECB, the World Bank, the Interamerican Development Bank, MEFF and the European
Investment Bank.
He is Associate Editor of Journal of Financial Intermediation, Review of Finance,
Journal of Banking and Finance and Journal of Financial Services Research.
His research contributions deal with the issues of payment systems risk, contagion and
the lender of last resort and the He is well known for his research work in the banking
area, that has been published in the main journals in the field, as well as for his book
Microeconomics of banking (MIT Press, 1997), co-authored with Jean-Charles Rochet.
75
1 Introduction
When the dust settles and the final numbers are tallied up, it should be of no surprise
if the massive support provided in the (ongoing) crisis to banks and other financial
institutions – directly in the form of assistance from governments and central banks,
and indirectly through support from international organisations, including to sovereigns
under stress – has meant that taxpayers, especially in Europe, have engaged in the largest
cross-border transfer of wealth since the Marshall Plan. The crisis has also shown that
the ad hoc solutions typically used to deal with failed globally systemically important
financial institutions (G-SIFIs)1 lead to much turmoil in international financial markets
and worsen the real economic and social consequences of crises.
Importantly, events have made abundantly clear (again) that, for all the efforts invested
in the harmonisation of rules and agreements to share more information, supervisors
had little incentive to genuinely cooperate before the crisis and did too little to help
prevent the weaknesses and failures of many G-SIFIs. These facts, together with the
ongoing turmoil in Europe and elsewhere, remind us of the high costs from not having
a system that can effectively and efficiently deal with G-SIFIs under stress.
A better approach to dealing with G-SIFIs is therefore sorely needed. Many policy
efforts are underway (by individual countries, the Basle Committee on Banking
1 While it is hard to define exactly what a G-SIFI is, and there can obviously not be a final list, the FSB (2011) lists 29 “G-SIFIs” for which certain resolution-related requirements will need to be met by end-2012.
Stijn ClaessensIMF, University of Amsterdam, and CEPR
How to prevent and better handle the failures of global systemically important financial institutions
Rethinking Global Economic Governance in Light of the Crisis
76
Supervision, the Financial Stability Board, the IMF, and others) to strengthen regulatory
and supervisory frameworks, improve the robustness of these institutions, and enhance
actual supervision internationally to prevent distress. At the same time, any approach
has to be based on clear analysis of the underlying problem and not on wishful think(er)
ing. Logic suggests starting from the endgame, ie, resolution – the process of how a
weak financial institution is (in part) liquidated, closed, broken up, sold, or recapitalised.
Specifically, the rules governing who is in charge of the restructuring and liquidation
process and how losses are allocated when a G-SIFI runs into trouble are crucial. The
endgame strongly affects supervisory incentives and market behaviour long before
difficulties arise. And the endgame rules affect the time-consistency problem, whether
or not an ad hoc bailout is, ex post, the most efficient solution.
As policymakers realise all too well, however, especially in Europe today, approaches
to the resolution of G-SIFIs can conflict with three other policy objectives – preserving
national autonomy, fostering cross-border banking and maintaining global financial
stability. These three objectives are not always mutually consistent; they create a
financial trilemma, and approaches to resolution have to operate within this trilemma.
In this paper, I examine the causes for the resolution problem of G-SIFIs and review
three approaches to improving cross-border resolution which address the financial
trilemma head on, acknowledging that solutions are to be found in partly giving up
fiscal and legal sovereignty or putting restrictions on cross-border banking.
2 Diagnosis of the current problem
The recent financial crisis has had multiple causes, with their relative importance still
being debated (for analyses and views, see the financial crisis issues of the Journal of
Economic Perspectives, Winter and Fall 2010; Winter 2009). One of the (approximate)
causes, however, was surely the behaviour of G-SIFIs (Claessens, Herring and
Schoenmaker, 2010). In part because of weak oversight, G-SIFIs took too much risk
Failures of global systemically important financial institutions
77
before the crisis. Moreover, during the crisis, a relatively small group of 30–50 G-SIFIs
became important causes of financial turmoil and channels for cross-border contagion.
Both through direct links, as in the case of interbank exposures, and through other
channels, such as the affect on asset prices and other financial markets and the threat to
essential financial infrastructures (for example, the payments system), their actions and
financial problems added to the overall real costs of the crisis.
Interventions in, and support for, weak G-SIFIs were aggravating the financial turmoil
and creating large fiscal and real costs. Many G-SIFIs have been the recipient of much
direct public support, in the forms of explicit guarantees and official recapitalisation,
and other forms of (implicit/indirect) support, such as when G20 governments
explicitly announced in the fall of 2008 that they would be protected or when central
banks provided more ample liquidity. As in other crises, this support has been very
costly and, while often hidden from the public view, has involved large transfers
between countries. Examples include the payouts made to foreign banks while the US
government provided support to AIG, public support to international banks like RBS,
ABN-Amro and the like, and the large implicit transfers – through the ECB and other
official support – to the sovereigns and banking systems of crisis-affected countries,
such as Greece, Ireland, Portugal and others.
In the aftermath of the crisis, reform efforts are focusing on how to make G-SIFIs more
robust to shocks and less prone to insolvency (through higher capital adequacy and
liquidity requirements and surcharges, and better liability structures). These reforms are
desirable. They can, however, come with some drawbacks in the form of higher costs
of financial intermediation, and may not necessarily make the systems more robust.
They can create incentives for more risk-taking and lead to risk shifting to other parts
of the financial system (eg, the shadow banking system), creating new systemic risks
in the process. Importantly, while much is being done to improve the (international)
supervision of G-SIFIs, many of the supervisory challenges will remain as long as
deficiencies exist in frameworks for resolving G-SIFIs and as long as resolution is
Rethinking Global Economic Governance in Light of the Crisis
78
internationally inconsistent. This view becomes obvious once one considers the state of
international financial integration and works backwards from the endgame of resolution.
Countries have become increasingly intertwined financially as cross-border claims
have grown much faster than trade and GDP. Much is this is due to a small number
of G-SIFIs that operate across the globe. Many of these institutions are very complex
(Herring and Carmassi, 2010). For example, the top 30 G-SIFIs have, on average, close
to 1,000 subsidiaries, of which some 70% operate abroad and some 10% in offshore
financial centres (Claessens, Herring and Schoenmaker, 2010). Complexity not only
makes many G-SIFIs difficult to manage, but can also cause them to have systemic
consequences. Importantly, a G-SIFI can be very difficult to wind down and become
‘too big to fail’. Many, not just the G-SIFIs themselves, argued during the crisis that if
a G-SIFI deeply involved in a wide range of countries were permitted to fail, this would
have repercussions that would affect financial systems and national economies around
the world. Indeed, as noted, many G-SIFIs were supported for this reason. Supporting
them was considered to be, ex post, the most efficient thing to do, given the likely
costs of letting them fail. Those few that did not get support created great havoc in
international financial markets.
What to do going forward when a G-SIFI runs into difficulties and potentially needs to
be resolved has thus become of crucial importance to a safer global financial system.
Clarity over the responsibilities in the resolution stage, including the allocation of any
costs, greatly matters for the incentives of relevant stakeholders in the preventive stages.
These stakeholders importantly include – besides various financial market participants
– the multiple supervisors responsible for G-SIFIs. By focusing insufficiently on the
need to improve the frameworks for cross-border resolution, ie, the endgame, however,
they may have failed to address the deeper problem. That this big lacuna is yet to be
rectified is not surprising, given its causes.
National authorities will have a natural inclination to focus on the impact of a G-SIFI
failure on their domestic systems (ie, to just consider national externalities) and to ignore
Failures of global systemically important financial institutions
79
the wider impact on the global financial system (ie, the cross-border externalities). The
dominance of the national perspective arises for two reasons (Freixas, 2003). First,
the financing typically required for dealing with a weak G-SIFI, and any direct costs
associated with final resolution, are borne by domestic taxpayers. Second, insolvencies
and bankruptcies are dealt with by national courts and resolution agencies that, in turn,
derive powers from national legislation. The resolution of a G-SIFI can then lead to
coordination failures, where each national authority only looks after its own interest
and nobody addresses the global interest.
Similar to the trilemma in international macroeconomics of a fixed exchange rate,
independent monetary policy and free capital mobility (Rodrik, 2000), a trilemma
arises in dealing with G-SIFIs. This financial trilemma (Schoenmaker, 2011) implies
that three policy objectives – preserving national autonomy, fostering cross-border
banking and maintaining global financial stability – are not always mutually consistent.
Solutions to the trilemma are to be found in partly giving up fiscal and legal sovereignty
or putting restrictions on cross-border banking. So far, countries have not chosen in a
coherent manner, leading to problems.
The theoretical possibility of coordination failure is born out in practice. In most cross-
border bank failures during the recent financial crisis, there was no, or at best partial,
coordination, which undermined confidence in the international financial system and
increased the costs borne by domestic taxpayers. The failures of Fortis, Lehman and the
Icelandic banks illustrate how damaging the lack of an adequate cross-border resolution
framework can be for global financial stability. The restructuring of many G-SIFIs on
a national basis led to major disruptions. The ongoing restructuring of European banks
(and sovereigns) in periphery countries (Greece, Iceland, Ireland, etc) involves large
(implicit) transfers, motivated in large part by the desire to preserve (regional) financial
stability, and shows the difficulties in achieving coordinated solutions. Only in some
cases have authorities reached a cooperative solution, as when they facilitated the
continuation of Western bank operations in Central and Eastern Europe, with relatively
Rethinking Global Economic Governance in Light of the Crisis
80
good outcomes. In the case of Dexia, which appeared for some time to have been a
good cooperative solution, the bank ended up being dissolved.
3 Possible solutions
To date, international supervisory efforts have focused on the harmonisation of rules
and increasing supervisory cooperation, while resolution – the endgame – has been
largely neglected. The crisis shows this approach is wrong. For all the harmonisation,
supervisors had little incentive to really cooperate, exchange information and intervene in
a coordinated manner. Rather, policymakers addressed most weak financial institutions
on their own, often with little regard for international consequences. A better solution
is to start from the endgame, resolution, since who is in charge and how losses are
allocated strongly affect incentives and behaviour long before difficulties arise.
Most countries, however, lack an effective framework for resolving even purely
national financial institutions. All too often, as in the recent crisis, the endgame is
instead determined under crisis conditions through frantic improvisations over a chaotic
weekend, with often no choice but to rescue the institution concerned at great cost. The
internationally operating SIFIs make this a global problem. While national reforms have
to be the starting point, there are three reform models that can help address the global
problem. The first two are corner solutions. The third is an intermediate approach.
The first reform model is a territorial approach under which assets are ring-fenced
so that they are first available for the resolution of local claims. There is no need for
burden-sharing or coordination, as each country manages the resolution of its own part
of the cross-border SIFI. This approach creates inefficiencies – a financial institution
has to manage capital and liquidity separately in each country – and compromises the
cross-border integration dimension of the financial trilemma. I reject this approach,
given the benefits from and the de facto state of financial integration.
Failures of global systemically important financial institutions
81
The second reform model is a universal approach under which all global assets are
shared equitably among creditors according to the legal priorities of the home country.
This approach can be combined with agreements for burden-sharing between countries,
including through some form of financial sector taxation (Claessens, Keen and
Pazarbasioglu, 2010), which can further strengthen the incentives for coordination in
resolution and supervision. In this model, in terms of the financial trilemma, national
autonomy is partly given up. This universal approach is probably only feasible and
desirable among closely integrated countries, such as those in the European Union.
The third reform model is a modified universal approach, ie, an intermediate approach
to address the financial trilemma. The modified universal approach implies that
countries need to adopt improved and converged resolution rules and require G-SIFIs
to have better resolution plans. While not giving up national sovereignty, countries do
need to agree to expand the principles for international supervision and possibly adopt
an enhanced set of rules governing cross-border resolutions (as in, say, a new Basel
Concordat on ‘Coordination of Supervision and Resolution of Cross-Border Banks’).
Of the three approaches to the resolution of G-SIFIs that address the trilemma, the
universal approach may be feasible, but only among closely integrated countries. The
territorial approach impedes efficient international financial integration. But following
the territorial approach is what, in many countries, the local regulators of the different
parts of a G-SIFI are actually required to do . Attention is largely focused on these two
options, but they represent either end of a spectrum, and neither can work effectively
in general. More realistic for most countries is a modified universal approach, which
requires G-SIFIs to put in place effective resolution plans, each country to adopt
improved resolution rules, and countries to jointly adopt a set of rules governing cross-
border resolutions that enhance predictability of official actions in a crisis and increase
market discipline before crisis conditions emerge.
For all approaches, there will be a need for a new paradigm in international policy
coordination. Efforts should move from a focus on whether national authorities can
Rethinking Global Economic Governance in Light of the Crisis
82
cooperate in international supervision and resolution, as reflected in the current
harmonisation model, to whether national authorities will cooperate. This will require
adopting a much more incentives-based approach, integrating regulation, supervision
and resolution policies and enshrining them in a new Concordat. With this, the global
financial system can become more predictable and safer, resolution in a crisis more
efficient and, through enhanced market discipline, crises less likely.
References
Claessens, S., R.J. Herring and D. Schoenmaker (2010), ‘A Safer World Financial
System: Improving the Resolution of Systemic Institutions’, Geneva Reports on the
World Economy 12, CEPR/ICMB.
Claessens, S., Michael Keen and Ceyla Pazarbasioglu (2010), Financial Sector Taxation:
The IMF’s Report to the G-20 (A Fair and Substantial Contribution) and Background
Material G-20 Report (Eds. joint with Michael Keen and Ceyla Pazarbasioglu), IMF,
Washington, DC, September.
Financial Stability Board (2011), Policy Measures to Address Systemically Important
Financial Institutions, November 4.
Freixas, X. (2003), “Crisis Management in Europe,” in J. Kremers, D. Schoenmaker
and P. Wierts (eds), Financial Supervision in Europe, Cheltenham: Edward Elgar, 102-
19.
Herring, R.J. and J. Carmassi (2010), “The Corporate Structure of International
Financial Conglomerates: Complexity and Its Implications for Safety and Soundness,”
in The Oxford Handbook of Banking, edited by A. Berger, P. Molyneux and J. Wilson.
Journal of Economic Perspectives, Symposium Volumes (2010), Winter and Fall;
(2009), Winter.
Failures of global systemically important financial institutions
83
Rodrik, D. (2000), “How Far Will International Economic Integration Go?” Journal of
Economic Perspectives 14, 177-186.
Schoenmaker, D. (2011), ‘The Financial Trilemma’, Economics Letters, 111, 57-59.
About the author
Stijn Claessens is Assistant Director in the Research Department of the IMF where
he leads the Financial Studies Division. He is also a Professor of International Finance
Policy at the University of Amsterdam where he taught for three years (2001-2004).
Mr. Claessens, a Dutch national, holds a Ph.D. in business economics from the
Wharton School of the University of Pennsylvania (1986) and M.A. from Erasmus
University, Rotterdam (1984). He started his career teaching at New York University
business school (1987) and then worked earlier for fourteen years at the World Bank
in various positions (1987-2001). Prior to his current position, he was Senior Adviser
in the Financial and Private Sector Vice-Presidency of the World Bank (from 2004-
2006). His policy and research interests are firm finance; corporate governance;
internationalization of financial services; and risk management. Over his career, Mr.
Claessens has provided policy advice to emerging markets in Latin America and Asia
and to transition economies. His research has been published in the Journal of Financial
Economics, Journal of Finance and Quarterly Journal of Economics. He had edited
several books, including International Financial Contagion (Kluwer 2001), Resolution
of Financial Distress (World Bank Institute 2001), and A Reader in International
Corporate Finance (World Bank). He is a fellow of the London-based CEPR.
85
The ongoing sovereign debt crisis in Europe continues to put strain not only on
banks’ balance sheets, but also on the single European banking market. Rather than
disentangling the sovereign debt and bank crises, recent policy decisions might have
tied the two even closer together. The use of the additional liquidity provided through
LTROs to stock up on government bonds by some banks has has certainly had this effect.
Moreover, while first steps have been taken to address sovereign debt illiquidity and
self-fulfilling prophecies of sovereign insolvency, there are still no proper mechanisms
in place to address either.
Last June, CEPR published a policy report titled Cross-border banking in Europe:
implications for financial stability and macroeconomic policies (Allen et al 2011) in
which the authors argued that policy reforms in micro- and macro-prudential regulation
and macroeconomic policies are needed for Europe to reap the important diversification
and efficiency benefits from cross-border banking, while reducing the risks stemming
from large cross-border banks. While the authors finalised this report in April 2011, the
organised default by Greece and the continuing doubts over the debt sustainability of
Portugal and concerns over some other peripheral states have reinforced the messages
in the report. The ongoing crisis has also reinforced regulatory instincts to focus on
national interests and stakeholders when it comes to cross-border banking.
Thorsten BeckTilburg University and CEPR
Cross-border banking in Europe: Policy challenges in turbulent times
Rethinking Global Economic Governance in Light of the Crisis
86
How did we get here?
The monetary union was supposed to be the crowning element for a single economic
area, eliminating exchange rate uncertainty and thus further boosting economic
exchange across borders and free flows of capital and labour. At the same time, a
regulatory framework for cross-border banking within Europe was established. The
introduction of the euro in 1999 eliminated currency risk and provided a further push for
financial integration (Kalemli-Ozcan et al 2010). Figure 1 illustrates this trend towards
increasing importance of cross-border banks across European financial systems.
Figure 1. Cross-border banking in the European Union
20
30
40
50
60
70
Sha
re o
f For
eign
Ban
ks
1995 1997 1999 2001 2003 2005 2007 2009
Year
European economies European transition economies European non-transition economies Source: Claessens and van Horen (2012)
When the 2007 crisis erupted in the US, cross-border banks were an important
transmission channel. In a financially integrated world, where large shares of assets
are traded on international markets and with high amounts of inter-bank claims across
borders, the contagion effects were pronounced and immediate, going through direct
cross-border lending, local lending by subsidiaries of large multinational banks and
lower access of local banks to international financing sources. While central banks
Cross-border banking in Europe: Policy challenges in turbulent times
87
coordinated well to address the liquidity crisis in the international financial markets,
regulators did not coordinate well when it came to dealing with failing financial
institutions, as became obvious in the cases of the Benelux bank Fortis and the Icelandic
banks. Over time, coordination improved, as was made most obvious by the Vienna
initiative (De Haas et al 2012).
The benefits and risks of cross-border banking
The benefits and risks of cross-border banking have been extensively analysed and
discussed by researchers and policymakers alike. The main stability benefits stem from
diversification gains; in spite of the Spanish housing crisis, Spain’s large banks remain
relatively solid, given the profitability of their Latin American subsidiaries. Similarly,
foreign banks can help reduce funding risks for domestic firms if domestic banks
run into problems. However, the costs might outweigh the diversification benefits if
outward or inward bank investment is too concentrated. Several central and eastern
European countries are highly dependent on a few western European banks, and the
Nordic and Baltic region are relatively interwoven without much diversification. At the
system level, the EU is poorly diversified and is overexposed to the US (Schoenmaker
and Wagner 2011). While regulatory interventions into the structure of cross-border
banking would be difficult if not counter-productive, a careful monitoring of these
imbalances is called for.
There are different market frictions and externalities that call for a special focus of
regulators on cross-border banks. First, cross-border banking increases the similarities
of banks in different countries and raises their interconnectedness which, in turn, can
increase the risk of systemic failures even though individual bank failures become
less likely due to diversification benefits (see, eg Wagner 2010). Second, national
supervision of cross-border banks gives rise to distortions as shown by Beck, Todorov
and Wagner (2011). The home-country regulator will be more reluctant to intervene in
a cross-border bank the higher the share of foreign deposits and assets, and more likely
Rethinking Global Economic Governance in Light of the Crisis
88
to intervene the higher the share of foreign equity. The reason for this is that a higher
asset and deposit share outside the area of supervisory responsibility externalises part
of the failure costs, while a higher share of foreign equity reduces the incentives to
allow the bank to continue, as the benefits are reaped outside the area of supervisory
responsibility.
The crisis of 2008 has clearly shown the deficiencies of both national resolution
frameworks, but especially of cross-border resolution frameworks. In the wake of the
crisis, attempts have been made to address these deficiencies, both on the national and
the European level. Following the de Larosière (2009) report, the European Banking
Authority (EBA) was established to more intensively coordinate micro-regulation
issues, while the European Systemic Risk Board (ESRB) is in charge of addressing
macro-prudential issues. Further-reaching reform suggestions, such as creating a
European-level supervisor with intervention powers or a European deposit insurance
fund with resolution powers modelled after the US FDIC or the Canadian CDIC, were
rejected, however, mostly based on arguments of the principle of subsidiarity, national
sovereignty over taxpayer money that might be needed for resolution of large cross-
border banks, and the need to amend European treaties.
Given the biased incentives of national regulators, however, there is a strong case
for a pan-European regulator with the necessary supervisory powers and resources.
While different institutional solutions are possible, a European-level framework for
deposit insurance and bank resolution is critical in order to enable swift and effective
intervention into failing cross-border banks, reduce uncertainty, and strengthen market
discipline. Depending on the choice of resolution authority (supervisor or central bank),
the new EBA or the ECB could be given this central power in the college of resolution
authorities. In addition, resolution plans for cross-border banks should be developed to
allow for an orderly winding down of (parts of) a large systemic financial institution.
As large financial institutions have multiple legal entities, interconnected through
intercompany loans, it is most cost effective to resolve a failing bank at the group level.
This can imply a splitting-up of the group, the sale of parts to other financial institutions
Cross-border banking in Europe: Policy challenges in turbulent times
89
and the liquidation of other parts. In this context, ex ante burden-sharing arrangements
should be agreed upon to overcome coordination failure between governments in the
moment of failure and ineffective ad hoc solutions. By agreeing ex ante on a burden-
sharing key, authorities are faced only with the decision to intervene or not. In that way,
authorities can reach the first-best solution. While burden-sharing should be applied at
the global level, it can only be enforced with a proper legal basis. That can be provided
at the EU level, or at the regional level. A first example, albeit legally non-binding, is
the Nordic Baltic scheme.
Linking financial and macro-stability
The Eurozone crisis is as much a sovereign debt and banking crisis as it is a crisis of
governance. As pointed out by many commentators, the aggregate fiscal position of
the Eurozone is stronger than that of the UK, the US, or Japan. However, the necessary
institutions to address macroeconomic imbalances within the Eurozone are missing.
While this holds true for many policy areas, most prominently fiscal policy, this has
become especially clear in the area of cross-border banking.
The crisis has raised fundamental questions on the interaction of monetary and
financial stability. While the inflation-targeting paradigm treated monetary and
financial stability as separate goals, with monetary policy aiming at monetary stability
and micro-prudential policy aiming at financial stability, the crisis has changed this
fundamentally. Inflation targeting was also behind the original Growth and Stability
Pact in the Maastricht Treaty and is the background for the recent Fiscal Compact.
This ignores, however, the close interaction between banking and the official sector,
including through banks holding governments bonds and the effects of asset and credit
bubbles. Examples from the crisis are Spain and Ireland, both of which fulfilled the
Maastricht criteria going into the crisis, but experienced real estate bubbles. In the
current policy debate, Germany is worried that low interest rates by the ECB, adequate
Rethinking Global Economic Governance in Light of the Crisis
90
to counter recessionary fears across most of the Eurozone, might fuel an asset bubble
in Germany.
This calls for the use of macroprudential regulation as additional policy tools. While
monetary policy should take into account asset, and not only consumer, price inflation,
one tool is simply not enough to achieve both goals, especially in currency unions where
asset price cycles are not completely synchronised across countries. Macroprudential
regulation cannot serve only to counter the risk of asset price bubbles, but also that
of asset concentration and herding. Such regulation would have to be applied on the
national, but monitored on the European level.
Another important issue is the close interlinkages between sovereign debt and banking
crises in the Eurozone. With banks holding a large share of government bonds (and
these bonds constituting a large share of banks’ assets), a sovereign debt restructuring
as just happened in Greece leaves banks undercapitalised, if not insolvent. In times
of crisis, incentives to hold government bonds (still considered risk-free thus with
no capital charges) increase as the risk profile of real sector claims increases (a trend
exacerbated by Basel II, as pointed out by many observers, eg Repullo and Suarez 2012).
The government debt overhang in many industrialised countries also creates a political
bias towards financial repression to reduce the costs of government debt, with further
pressure for financial institutions to hold domestic government debt (Kirkegaard and
Reinhart 2012). This close interaction between banks and sovereigns also influences
policy stances, such as that of the ECB until late last year when it opposed even any
talk about sovereign debt restructuring as this would prevent it from accepting Greek
sovereign debt as collateral for banks.
One possibility to separate sovereign debt and banking crises was suggested by Beck,
Uhlig and Wagner (2011) and Brunnermeier et al (2011). Beck et al suggest creating
a European debt mutual fund, which holds a mixture of the debt of Eurozone members
(for example, in proportion to their GDP). This fund then issues tradeable securities
whose payoffs are the joint payoffs of the bonds in its portfolio. If one member country
Cross-border banking in Europe: Policy challenges in turbulent times
91
defaults or reschedules its debt, this will likewise affect the payoff of these synthetic
Eurobonds, but in proportion to the overall share in its portfolio. As Greek’s share would
be small (it makes up about 2% of Eurozone GDP), its default would not have posed a
significant risk to the Eurobond. Brunnermeier et al (2011) suggest a similar structure,
though with two tranches of senior and junior debt, with only senior debt being used for
banks’ refinancing operations with the ECB. Obviously, such a synthetic Eurobond, or
“ESBie”, would only help separate the two crises, but would not solve either of them.
In the case of banking distress, a proper resolution framework is needed, as discussed
above. In the case of a sovereign debt crisis, a formal insolvency procedure should be
put in place, while at the same time a better firewall is needed to prevent a liquidity
crisis in sovereign bonds turning into a self-fulfilling solvency crisis.
Conclusions
Don’t let a good crisis go to waste! This has been a popular cri de guerre following the
2007–08 crisis. Europe, and especially the Eurozone, did too little after the 2007–08
crisis to address the institutional gaps in the framework that is needed for (i) a stable
European banking market, and (ii) the interlinkages between monetary and financial
stability. It has left policymakers with too few policy tools and coordination mechanisms
during the current crisis.
Beyond the lack of proper policy tools and mechanisms, the Eurozone faces a deeper
crisis – that of a democratic deficit for the necessary reforms to make this monetary
union sustainable in the long run. Political resistance in both core and periphery
countries against austerity and bailouts illustrates this democratic deficit. In the long
term, the Eurozone can only survive with the necessary high-level political reforms.
It is in the context of such a political transformation of the Eurozone that many of the
reforms outlined in this column will be significantly easier to implement.
Rethinking Global Economic Governance in Light of the Crisis
92
References
Allen, F, T Beck, E Carletti, P Lane, D Schoenmaker and W Wagner (2011), Cross-
border banking in Europe: implications for financial stability and macroeconomic
policies, CEPR, London.
Beck, T, H Uhlig and W Wagner (2011), “Insulating the financial sector from the
European debt crisis: Eurobonds without public guarantees”, VoxEU.org, 17 September
Beck, T, R Todorov, and W Wagner (2011), “Supervising Cross-Border Banks: Theory,
Evidence and Policy”, Tilburg University Mimeo.
Brunnermeier, M, L Garicano, P R. Lane, M Pagano, R Reis, T Santos, D Thesmar,
S Van Nieuwerburgh, and D Vayanos (2011), “ESBies: a realistic reform of Europe’s
financial architecture”, VoxEU, 25 October.
Claessens, S, and N van Horen (2012), “Foreign Banks: Trends, Impact and Financial
Stability”, IMF Working Paper WP/12/10.
De Haas, R, Y Konniyenko, E Loukoianova, E and A Pivovarsky (2012) “Foreign banks
and the Vienna Iniative turning sinners into saints”, EBRD Working Paper 143.
De Larosière (2009), Report of the High-Level Group on Financial Supervision in the
EU, Brussels: European Commission.
Kalemli-Ozcan, S, E Papaioannou and J Peydró (2010), “What Lies Beneath the
Euro’s Effect on Financial Integration? Currency Risk, Legal Harmonization or Trade”,
Journal of International Economics 81, 75–88.
Kirkegaard, J F and C Reinhart (2012), “Financial Repressions: Then and Now”,
VoxEU.org, 26 March.
Repullo, R and J Suarez (2012), “The Procyclical Effects of Bank Capital Regulation”,
CEMFI mimeo.
Cross-border banking in Europe: Policy challenges in turbulent times
93
Schoenmaker, D and W Wagner (2011), “The Impact of Cross-Border Banking on
Financial Stability”, Duisenberg School of Finance, Tinbergen Institute Discussion
Paper, TI 11-054 / DSF 18.
Wagner, W (2010), ‘Diversification at Financial Institutions and Systemic Crises’,
Journal of Financial Intermediation 19, 272-86.
Rethinking Global Economic Governance in Light of the Crisis
94
About the author
Thorsten Beck is Professor of Economics and Chairman of the European Banking
CentER at Tilburg University. Before joining Tilburg University in 2008, he worked
at the Development Research Group of the World Bank. His research and policy work
has focused on international banking and corporate finance and has been published in
Journal of Finance, Journal of Financial Economics, Journal of Monetary Economcis
and Journal of Economic Growth. His operational and policy work has focused on
Sub-Saharan Africa and Latin America. He is also Research Fellow in the Centre for
Economic Policy Research (CEPR) in London and a Fellow in the Center for Financial
Studies in Frankfurt. He studied at Tübingen University, Universidad de Costa Rica,
University of Kansas and University of Virginia.
95
Credit default swaps (CDSs) are derivatives, financial instruments sold over the counter
(OTC). They transfer the credit risk associated with corporate or sovereign bonds to a
third party, without shifting any other risks associated with such bonds or loans.
According to Trade Information Warehouse Reports on OTC Derivatives Market
Activity, the outstanding gross notional value of live positions of CDS contracts stood
at $15 trillion on 31 August 2011 across 2,156,591 trades. The original use of a CDS
contract was to provide insurance against unexpected losses due to a default by a
corporate or sovereign entity. The debt issuer is known as the reference entity, and a
default or restructuring on the predefined debt contract is known as a credit event. In
the most general terms, this is a bilateral deal where a ‘protection buyer’ pays a periodic
fixed premium, usually expressed in basis points of the reference asset’s nominal value,
to a counterpart known by convention as the ‘protection seller’. The total amount paid
per year as a percentage of the notional principal is known as the CDS spread. Most
features of sovereign CDSs are identical to those of corporate ones, except that for
sovereigns there may be fewer asymmetries of information among market participants,
as most relevant information about the health of the economy and public finances is
common knowledge.
While CDS contracts written on sovereign names accounted for half the size of the
CDS market in 1997, in the early 2000s this ratio declined to 7%. The market share of
Richard PortesLondon Business School and CEPR
Credit default swaps in Europe*
* The discussion here in good part summarises research that is joint with Giorgia Palladini and is available as CEPR Discussion Paper 8651, “Sovereign CDS and Bond Price Dynamics in the Eurozone”, November 2011, and financed by PEGGED. We used data from CMA for our empirical analysis. But Giorgia Palladini is not responsible for my interpretations of our results, nor for my assessment of the role of naked CDSs.
Rethinking Global Economic Governance in Light of the Crisis
96
sovereign CDSs dropped to 5% at the end of 2007, with contracts written on emerging
economies accounting for over 90% of the global volume of trade. Since the Eurozone
debt crisis began, however, the share of sovereign CDSs has risen sharply. At the end
of May 2010, the gross notional value of the whole CDS market accounted for $14.5
trillion, with about 2.1 million contracts outstanding. The sovereign segment of the
market reached $2.2 trillion, with 0.2 million contracts. Hedge funds, global investment
banks, and non-resident fund managers seem to be the most active participants in the
market.
Before the introduction of credit derivatives, there was no way to isolate credit risk
from the underlying bond or loan. The CDS market has filled this gap, and it may be
regarded as a useful financial innovation, subject to (a) verification that it performs
this function efficiently; (b) assurance that it has not been transformed into a highly
speculative market in ‘naked CDSs’ that perform no hedging function and serve in
particular merely to make bets on the future of financial firms and sovereigns that can
destabilise them. We address these issues in turn.
The CDS market has drawn increasing attention from practitioners, regulators, and
even politicians. Yet much of the existing research used data from the early period of the
market’s development, and there is little focus on the segment of greatest policy interest,
the Eurozone sovereign bond market. That policy focus may itself be misplaced, because
the CDS market may be more destabilising for financial firms than for sovereigns.
Regardless, it was the politicians’ concern about the role of CDSs on Greece starting
in spring 2010 that drove subsequent action by the European Commission and the
European Parliament.
As Duffie (1999) and related literature point out, a theoretical no-arbitrage condition
between the cash and synthetic price of credit risk should drive investment decisions
and tie up the two credit spreads in the long run. Insofar as credit risk is what they
price, cash and CDS market prices should reflect an equal valuation, in equilibrium. If
in the short run they are affected by factors other than credit risk, such elements may
Credit default swaps in Europe
97
partially obscure the comovement between bond yield spreads and CDS premia. The
first contribution of our research has therefore been to check the accuracy of credit risk
pricing in the CDS market. Does the market perform an important role in providing
useful information to market participants and other observers?
We proceed by comparing the theoretically implied CDS premia with the ones
established by the market. The existence of a stable relationship between the two credit
spreads implies a long-run connection between bonds and CDS contracts on the same
reference entity, in our case a sovereign. On the one hand, this rules out the possibility
that credit risk is priced in unrelated ways in the derivative and cash markets. On the
other, we cannot discard the hypothesis that large common pricing components rather
than credit risk affect both prices to some extent.
Our research has also addressed the relative efficiency of credit risk pricing in the
bond and CDS market. Here we are concerned with the ‘price discovery’ relationship
between CDS and bond yield spreads. In particular, can the CDS market anticipate the
bond market in pricing, or does it merely adapt to the cash market valuation of credit
risk?
Several recent papers study the credit derivative markets. The majority focus on CDS
contracts written on corporate bonds1, and their data do not cover the past several years,
in which the CDS market grew rapidly and then went through the financial crisis. Of
the few papers devoted to the study of sovereign CDS spreads, most focus on emerging
markets. We know of only two papers on sovereign credit risk in the European Union
based on CDS market data.2 The size of the markets, the intrinsic interest of the recent
period, and the policy relevance of CDS market performance would seem to justify our
further work using a different approach.
1 Hull et al (2004) and Blanco et al (2005). 2 Arce et al (2011) and Fontana and Scheicher (2010).
Rethinking Global Economic Governance in Light of the Crisis
98
Our sample period runs from 30 January 2004 through 11 March 2011. The time span
covered by the regression analysis is equal for each country, at the price of using fewer
observations. We restricted our analysis to six countries for which daily estimates of
five-year government bond yields are available on DataStream market curve analysis, to
make sure that market data are reasonably comparable. Stored government bond yield
curves were available for nine EU countries. Among those, CDS quotes for Spain were
available for only 1,556 days, instead of 1,879 as for the rest of the sample. Therefore,
Spain has been excluded from the analysis. The countries in our resulting sample are
Austria, Belgium, Greece, Ireland, Italy, and Portugal.
Our empirical analysis confirms that that the two prices are equal to each other in
long-run equilibrium, as theory predicts. One interpretation is that the derivative market
correctly prices credit risk: sovereign CDS contracts written on Eurozone borrowers
seem to be able to provide new up-to-date information to the sovereign cash market
during the period 2004–11. We find, however, that in the short run the cash and synthetic
markets price credit risk differently to various degrees. Note also that even if the CDS
market prices credit risk ‘correctly’ in the long run, that does not mean that credit risk
as priced by either the CDS or the cash market reflects ‘fundamentals’.
In general, our results show that the derivative market seems to move ahead of the
bond market in price discovery. This goes in line with the results of Zhu (2006), but
contrasts with Ammer and Cai (2011), suggesting that the dynamics for developing and
developed economies may be very different as far as sovereign credit risk is concerned.
According to our findings, Eurozone sovereign risk seems to behave closer to developed
countries’ corporate credit risk than to developing economies’ sovereign risk.
A second aspect of our empirical work provides information about the dynamics
of adjustment to the long-term equilibrium between sovereign CDS and bond yield
spreads. Deviations from the estimated long-run equilibrium persist longer than if
market participants in one market could immediately observe the price in the other,
consistent with the hypothesis of imperfections in the arbitrage relationship between
Credit default swaps in Europe
99
the two markets. Probably due to its liquid nature, the Eurozone CDS market seems
to move ahead of the corresponding bond market in price adjustment, both before and
during the crisis.
There is an alternative causal interpretation of our results. The CDS market may lead
in price discovery because changes in CDS prices affect the fundamentals driving the
prices of the underlying bonds. If the CDS spread affects the cost of funding of the
sovereign (or corporate), then a rise in the spread will not merely signal but will cause a
deterioration in credit quality, hence a fall in the bond price (see Bilal and Singh 2012).
Such a mechanism could be destabilising; we discuss this further below. Moreover,
speculative use of CDS may ‘divert capital away from potential borrowers and channel
it into collateral to support speculative positions. The resulting shift in the cost of debt
can result in an increased likelihood of default and the amplification of rollover risk’
(Che and Sethi 2011).
Indeed, the change in spread may not signal at all: various non-fundamental determinants
can affect the spreads (as in Tang and Yan 2010) and therefore the fundamentals of the
reference entity. To confront this hypothesis with the data will require a dynamic model
admitting multiple equilibria. Research along these lines is just beginning (eg, Fostel
and Geanakoplos 2012).
We now turn to naked CDSs. The CDS market began in the late 1990s as a pure
insurance market that permitted bondholders to hedge their credit exposure – an
excellent innovation. But then market participants realised that they could buy and
sell ‘protection’ even if the buyer did not hold the underlying bond. This is a naked
CDS, which offers a way to speculate on the financial health of an issuing corporate or
sovereign without risking capital, as short-selling would do. That was so attractive that
soon the market was dominated by naked CDSs, with a volume an order of magnitude
greater than the stock of underlying bonds.
Like almost all the financial innovations in recent years, naked CDSs are said to be
a beneficial move towards more complete markets. And speculation, we are told, is
Rethinking Global Economic Governance in Light of the Crisis
100
essential to the proper functioning of markets. This is simply market fundamentalism
that ignores masses of research on destabilising speculation as well as a key lesson of
the financial crisis, that some innovations have been dysfunctional and dangerous.
A much more serious justification of naked CDSs is that the overall CDS market, of
which these are the dominant component, improves pricing efficiency. The CDS market
leads the cash bond market in price discovery and in predicting credit events. Our
empirical results appear to bear this out, at least for sovereign bonds in several countries
of the Eurozone. Smart traders in the market reveal information, and the CDS market
can provide information when the bond markets are illiquid. Still, ‘leadership’ may be
the result not of better information, but of the effect of CDS prices on the perceived
creditworthiness of the issuer. We return to this key issue below.
CDS prices have many defects as information. They are often demonstrably unrelated
to default probabilities – as when the German or UK sovereign CDS price rises; or
when corporate prices are less than those for the country of residence, even though the
corporate bond yield is much higher than that on the country’s government bond. Many
highly variable factors influence the CDS-bond spread: liquidity premia, compensation
for volatility, accumulating counterparty risk in chains of CDS contracts. What do
pricing efficiency and the informational content of prices mean in a highly opaque
market, where much of the information is available only to a few dealers?
Some argue that because net CDS exposures are only a few percent of the stock of
outstanding government bonds, ‘the tail can’t wag the dog’, so the CDS market can’t be
responsible for the rising spreads on the bonds. This of course contradicts the argument
that the CDS market leads in price discovery because of its superior liquidity. More
important, it is nonsense. Over a period of several days in September 1992, George
Soros bet around $10 billion against sterling, and most observers believe that this
significantly affected the market – and the outcome. But daily foreign exchange trading
in sterling then before serious speculation began was somewhat over $100 billion. The
Soros trades were small relative to the market, yet they had a huge impact, just as the
Credit default swaps in Europe
101
CDS market can move the market for the underlying now. The issue is how CDS prices
affect market sentiment – in particular, whether they serve as a coordinating device for
speculation. We return to this below.
Perhaps the weakest argument is that banning naked CDSs “would also confine hedging
to a world of barter, requiring one to find those with opposite hedging needs” (Financial
Times 2010). If the insurer doesn’t want to take on the risk, it shouldn’t be selling
insurance.
Some say that naked CDSs are justified because they add liquidity to the market. But is
the extra liquidity worth the costs? And we now turn to these.
The most obvious argument against naked CDSs is the moral hazard arising when it
is possible to insure without an ‘insurable interest’ – as in taking out life insurance on
someone else’s life (unless she is a key executive in your firm, say).
The most important concern is related to this moral hazard. Naked CDSs, as a
speculative instrument, may be a key link in a vicious chain. Buy a CDS low, push down
the underlying (eg, short it), and take a profit from both. Meanwhile, the rise in CDS
prices will raise the cost of funding of the reference entity – it normally cannot issue at
a rate that will not cover the cost of insuring the exposure. That will harm its fiscal or
cash flow position. Then there will be more bets on default, or at least on a further rise
in the CDS price. If market participants believe that others will bet similarly, then we
have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating
agencies, which follow rather than lead. There is clearly an incentive for coordinated
manipulation, and anyone familiar with the markets can cite examples which look very
much like this. The probability of default is not independent of the cost of borrowing
– hence there may be multiple equilibria, with self-fulfilling expectations (see Cohen
and Portes, 2006).
The mechanism of CDSs is like that of reinsurance. The fees are received up front, the
risks are long-term, with fat tails. There are chains of risk transfer – a CDS seller will
Rethinking Global Economic Governance in Light of the Crisis
102
then hedge its position by buying CDSs. So the net is much less than the gross, but the
chain is based on the view that each party can and will make good on its contract. If
there is a failure, the rest of the chain is exposed, and fears of counterparty risk can cause
a drying-up of liquidity. The long chains may create large and obscure concentration
risks as well as volatility, since uncertainty about any firm echoes through the system.
Naked CDSs increase leverage to the default of the reference entity. They can thereby
substantially increase the losses that come from defaults. And the leverage comes at low
cost – nothing equivalent to capital requirements, no reserve requirement of the kind
insurers must satisfy.
What are the policy implications? We do find that for Eurozone sovereign debt, the
CDS and cash market prices are normally equal to each other in long-run equilibrium,
as theory predicts. One interpretation is that the derivative market prices credit risk
correctly: sovereign CDS contracts written on Eurozone borrowers seem to be able
to provide new up to date information to the sovereign cash market during the period
2004–11. In the short run, however, the cash and synthetic markets price credit risk
differently to various degrees. Second, the Eurozone CDS market seems to move ahead
of the corresponding bond market in price adjustment, both before and during the crisis.
CDS contracts written on Eurozone borrowers seem to be able to provide new up to
date information to the sovereign cash market during the period 2004–11. And CDS
contracts clearly do play a useful hedging role. None of this, however, justifies naked
CDSs, which appear to play a destabilising role both in theory and in various episodes
of the financial crisis.
Credit default swaps in Europe
103
References
Ammer J and F Cai (2011), “Sovereign CDS and Bond Pricing Dynamics in Emerging
Markets: Does the Cheapest-to- Deliver Option Matter?”, Journal of International
Financial Markets, Institutions and Money, 21(3):369–87.
Arce O, S Mayordomo, and J I Pena (2011), “Do sovereign CDS and Bond Markets
Share the Same Information to Price Credit Risk? An Empirical Application to the
European Monetary Union Case”, Federal Reserve Bank of Atlanta Working Paper.
Bilal, M and M Singh (2012), “CDS Spreads in European Periphery - Some Technical
Issues to Consider”, IMF Working Paper WP/12/77.
Blanco R, S Brennan, and I W Marsh (2005), “An Empirical Analysis of the Dynamic
Relation between Investment-Grade Bonds and Credit Default Swaps”, Journal of
Finance 60(5): 2255–81.
Che, Y-K and R Sethi (2011), “Credit derivatives and the cost of capital”, mimeo,
Columbia University.
Cohen, D and R Portes (2006), “A lender of first resort”, IMF Working Paper P/06/66.
Duffie, D (1999), “Credit Swap Valuation”, Financial Analysts Journal 55(1): 73–87.
Financial Times (2010), “Europe’s sovereign credit default flop”, editorial, 10 March.
Fontana A and M Scheicher (2010), “An Analysis of Eurozone Sovereign CDS and
Their Relation with Government Bonds” ECB Working Paper Series No. 1271.
Fostel A and J Geanakoplos (2012), “Tranching, CDS and Asset Prices: How
Financial Innovation can Cause Bubbles and Crashes”, American Economic Journal:
Macroeconomics 4(1): 190–225.
Rethinking Global Economic Governance in Light of the Crisis
104
Hull J, M Predescu, and A White (2004), “The Relationship Between Credit Default
Swap Spreads, Bond Yields, and Credit Rating Announcements”, Journal of Banking
and Finance 28(11): 2789–2811.
Tang D and H Yan (2010), “Does the Tail Wag the Dog? The Price Impact of CDS
Trading”, mimeo.
Zhu H (2006), “An Empirical Comparison of Credit Spreads between the Bond Market
and the Credit Default Swap Market”, Journal of Financial Services Research 29 (3):
211–35.
Credit default swaps in Europe
105
About the author
Richard Portes, Professor of Economics at London Business School, is Founder and
President of the Centre for Economic Policy Research (CEPR), Directeur d’Etudes at
the Ecole des Hautes Etudes en Sciences Sociales, and Senior Editor and Co-Chairman
of the Board of Economic Policy. He is a Fellow of the Econometric Society and of
the British Academy. He is a member of the Group of Economic Policy Advisers to
the President of the European Commission, of the Steering Committee of the Euro50
Group, and of the Bellagio Group on the International Economy. Professor Portes was a
Rhodes Scholar and a Fellow of Balliol College, Oxford, and has also taught at Princeton,
Harvard, and Birkbeck College (University of London). He has been Distinguished
Global Visiting Professor at the Haas Business School, University of California,
Berkeley, and Joel Stern Visiting Professor of International Finance at Columbia
Business School. His current research interests include international macroeconomics,
international finance, European bond markets and European integration. He has written
extensively on globalisation, sovereign borrowing and debt, European monetary issues,
European financial markets, international capital flows, centrally planned economies
and transition, macroeconomic disequilibrium, and European integration.
107
The worldwide financial crisis that erupted in 2007 has revealed the fragility of major
financial institutions, and triggered the sharpest global recession since the 1930s. Before
the crisis, standard macro theory largely abstracted from financial intermediaries, and
macro forecasting models ignored information on bank balance sheets. The dramatic
events since 2007 require a rethinking of the role of global finance for real activity,
and will represent a challenge for economic research for years to come. Several of
my PEGGED research projects have addressed this challenge, by presenting novel
theoretical and empirical analyses of the role of global banks for business cycles in the
EU and in the world economy. These contributions also highlight the stabilising role of
government support to banks, during a financial crisis.
A tractable framework for analysing the interaction between banks and the real economy
is provided by Kollmann, Enders and Müller (2011). That study incorporates a global
bank into a two-country macroeconomic simulation model. The bank collects deposits
from households and makes loans to entrepreneurs, worldwide. It has to finance a
fraction of loans using equity. In equilibrium, the loan rate exceeds the deposit rate – the
loan rate spread is a decreasing function of the bank’s capital. Hence, bank capital is a
key state variable for domestic and foreign real activity. The simulation model predicts
that a loan loss shock originating in one country lowers the capital of the global banking
system; this raises lending rate spreads worldwide, triggering a global reduction in bank
lending and a worldwide recession. That framework can thus account for the fact that
the financial crisis originated in the US, but spread very rapidly to the EU and the rest
of the world – the key role of globally active European banks in the transmission of the
Robert KollmannECARES, Université Libre de Bruxelles and CEPR
Global banks, fiscal policy and international business cycles
Rethinking Global Economic Governance in Light of the Crisis
108
crisis is highlighted by that fact that credit losses of European banks during the crisis
were largely due to foreign (US) loans.
In Kollmann (2012), I estimate the two-country model of Kollmann, Enders and
Müller (2011); the statistical results confirm the key role of global banks in the crisis
transmission. The study finds that Eurozone investment is especially sensitive to
shocks to the health of global banks – about 50% of the fall in EZ investment during
the crisis can be explained by shocks to the banking system. Kollmann and Zeugner
(2011) present further empirical evidence that underscores the role of bank balance
sheet conditions for real activity. Specifically, that study analyses the predictive power
of bank leverage for real activity. The key result is that bank leverage is negatively
correlated with the future growth of real activity – the predictive capacity of leverage
is roughly comparable to that of the standard macro and financial predictors used by
forecasters. Kollmann and Zeugner also document that leverage is positively linked to
the volatility of future real activity and of equity returns. This finding is consistent with
the view that higher bank leverage amplifies the effect of unanticipated macroeconomic
and financial shocks on real activity and asset prices, i.e. that higher leverage makes the
economy more fragile.
The key role of bank health for the overall economy suggests that government support
for the banking system might be a powerful tool for stabilising real activity in a financial
crisis. In fact, an important dimension of fiscal policy during the crisis was massive state
aid for banks, e.g. in the form of purchases of bank assets and of bank recapitalizsations
by governments. Kollmann, Roeger and in’t Veld (2012) point out that, in the US and the
EU, these “unconventional” fiscal interventions were larger than “conventional” fiscal
stimulus measures (temporary increases in government purchases and social transfers,
tax cuts). Conventional fiscal stimulus measures in the US amounted to 1.98% and
1.77% of US GDP in 2009 and 2010. In the EU, the conventional stimulus amounted
to 0.83% and 0.73% of EU GDP in 2009 and 2010, respectively. Bank rescue measures
mainly occurred in 2009. In the EU, government purchases of impaired (“toxic”)
bank assets and bank recapitalisations in 2009 amounted to 2.8% and 1.9% of GDP,
Global bBanks, fiscal policy and international business cycles
109
respectively. US government asset purchases and recapitalisations represented 1.6%
and 3.1% of GDP in 2009, respectively. In both the US and the EU, these two types of
bank support measures thus amounted to 4.7% of GDP, in 2009. Table 1 documents the
time profile of cumulated state aid for banks in the Eurozone, between February 2009
and April 2011.
Table 1. Eurozone state aid for banks (cumulative, as % of GDP)
Feb 2009
May 2009
Aug 2009
Dec 2009
Oct 2010
Dec 2010
Apr 2011
Purchases of impaired bank assets
0.43 0.45 0.75 2.84 2.15 2.00 1.94
Recapitalisations 1.09 1.45 1.67 1.88 2.17 2.21 2.11
Total bank aid 1.52 1.90 2.42 4.72 4.32 4.21 4.05
Source: in’t Veld and Roeger (2011) Laeven and Valencia (2011).
Surprisingly, the macroeconomic effects of these sizable bank support measures have
received little attention in the economics literature. Kollmann, Roeger and in’t Veld
(2012) and Kollmann, Ratto, Roeger and in’t Veld (2012) seek to fill this gap, by
adding a government to the banking model of Kollmann, Enders and Müller (2011).
Government support for the banking system is modelled as a transfer to banks that is
financed by higher taxes. Kollmann, Ratto, Roeger and in’t Veld (2012) and Kollmann,
Roeger and in’t Veld (2012) show that state aid to banks boosts bank capital, and that it
lowers the spread between the bank lending rate and the deposit rate, which stimulates
investment and output; the macroeconomic efficacy of state bank aid hinges on its
ability to lower the lending spread. Investment drops sharply in financial crises. Hence,
government support for banks helps to stabilise a component of aggregate demand
that is especially adversely affected by financial crises. By contrast, most conventional
fiscal stimulus measures (e.g. government purchases of goods and services) crowd out
investment. Kollmann, Ratto, Roeger and in’t Veld (2012) and Kollmann, Roeger and
in’t Veld (2012) show that the GDP multiplier of state aid to banking is in the same
range as conventional government spending multipliers.
Rethinking Global Economic Governance in Light of the Crisis
110
References
in’t Veld, J. and Roeger, W. (2011), “Evaluating the Macroeconomic Effects of State
Aids to Financial Institutions in the EU”, Working Paper, European Commission.
Kollmann, R., Enders, Z. and Müller, G. (2011), “Global banking and international
business cycles”, European Economic Review 55, 407-426.
Kollmann, R. and Zeugner, S. (2011), “Leverage as a Predictor for Real Activity and
Volatility,” Journal of Economic Dynamics and Control, forthcoming.
Kollmann, R., Roeger, W. and in’t Veld, J. (2012), “Fiscal Policy in a Financial Crisis:
Standard Policy vs. Bank Rescue Measures”, American Economic Review (Papers and
Proceedings), forthcoming.
Kollmann, R., Ratto, M., Roeger, W. and in’t Veld, J. (2012), “Banks, Fiscal Policy and
the Financial Crisis”, Working Paper, ECARES, Université Libre de Bruxelles.
Kollmann, R. (2012), “Global Banks, Financial Shocks and International Business
Cycles: Evidence from an Estimated Model”, Working Paper, ECARES, Université
Libre de Bruxelles.
Laeven, L. and Valencia, F. (2011), “The Real Effects of Financial Sector Interventions
During Crises”, Working Paper 11/45, IMF.
About the author
Robert Kollmann is a Professor of Economics at the Universite Libre de Bruxelles.
He obtained his PhD from the University of Chicago in 1991. His research interests are
macroeconomics, international finance and computational economics.
111
By 2012, it has been widely accepted that the Doha Round of multilateral trade
negotiations, launched in 2001, has reached an impasse. Even in 2011, when it was no
longer credible to deny the prospect of failure, governments were unable to break the
impasse (see Singh Bhatia 2011). That a multilateral trade negotiation has reached an
impasse is not new, at least one occurred during the Uruguay Round. Moreover, it is
misleading to think of impasses as only affecting the final stage of a multilateral trade
negotiation.1 Arguably, WTO members have been unable to agree at three junctures
during the Doha Round, namely:
• Failure to agree to launch the Doha Round (1995–September 2001, including the
acrimonious WTO ministerial meeting in Seattle).
• Failure to agree on a negotiating agenda for the Doha Round (from 2002 up to the
“July package” of 2004, and including the failed Cancun meeting of WTO minis-
ters).
• Failure to conclude the negotiation (at a minimum from the mid-2008 breakdown in
negotiations through to the present day).
What is new is the pervasive sense that it may not be possible to find steps that command
broad enough support among the WTO membership to break the current negotiating
deadlock. This leaves the WTO flying on one less engine, it is now being powered by
the dispute settlement function and weaker transparency and deliberative functions.
1 The WTO’s Director-General, Mr. Pascal Lamy, noted, in remarks to the WTO General Council on 29 April 2011, that “this Round is once more on the brink of failure.”
Simon J EvenettUniversity of St. Gallen and CEPR
The Doha Round impasse
Rethinking Global Economic Governance in Light of the Crisis
112
This paper describes the underlying sources of the impasse and considers what those
findings imply for how scholars, in particular international trade economists, might
analyse multilateral trade negotiations. As will be argued below, there has been far too
much analysis in recent years on the logic underlying successfully negotiated trade
agreements and too little on understanding the factors that might impede or facilitate
identifying the basis of the deal in the first place. Fortunately, game theorists and
international relations scholars have given more attention to the study of impasses, and
this might provide a useful point of departure for further research.
The realities of multilateral trade negotiations and national imperatives
When presented with a possible trade agreement by his staff, it is said that the former
US Trade Representative, Robert Zoellick, would ask “What is the basis of the deal?”
In short, what does each party contribute to the deal, what does each party gain from
the deal, and is there a compelling logic for who gains what? This approach serves as a
useful reminder that successful trade negotiations involve contributions by each major
party (having influence requires foreswearing free riding and being seen to do so by
trading partners), and that whatever negotiating rules are adopted (such as the single
undertaking and less than full reciprocity in favour of developing countries) do not
eliminate all of the possible mutually acceptable deals.
The need to be seen to contribute to deals—which in trade policy, if not strictly economic,
terms means making “concessions” to liberalise own markets—cuts against the task the
trade negotiator has at home, namely, to maintain support for the trade negotiation and
generate enough support for the final deal. The temptation, when managing domestic
constituencies, is for trade negotiators to assure some constituencies that their nation’s
concessions will be minimised while assuring others that a deal will be unacceptable
unless other countries don’t make more concessions.
The Doha Round impasse
113
All too often, this amounts to characterising their nation’s negotiating position to
domestic audiences as demanding “something for nothing.” While the trade negotiator
is undertaking this delicate dance at the national level, they are also trying to send
a different signal to their foreign counterparties, specifically, their willingness and
capacity to negotiate. All of this happens in a world where the many nations’ media
report statements made by foreign trade officials! Throughout the Doha Round, many
trade negotiators have given the impression that they could effectively spot “landing
zones” among the “smoke and mirrors,” a claim that may need to be revisited in the
light of a prolonged impasse. This time around, perhaps trade negotiators were too
clever by half. The potential for miscalculation cannot be ruled out.
Yet trade negotiators are not the only relevant players. Defensive domestic constituencies
have grown wise to trade negotiators’ tactics and incentives2, by and large distrust
them, and have taken steps to protect their interests. One such step is to insist that a
trade negotiator’s ministerial masters or the national legislature impose a negotiating
mandate that officials dare not breach. Not only do negotiators resent the encroachment
on their freedom to negotiate, but surely this makes it harder to reach a mutually
acceptable deal? Not necessarily, as Nobel Laureate Thomas Schelling argued in his
famous “conjecture” on international negotiations (Schelling 1960). Schelling argued
that if one major party to a negotiation could credibly commit not to offer concessions
beyond a certain point and, at that point, the other parties are materially better off by
making the deal than not making the deal, then the former party’s commitment device
can shift the negotiating outcome in its favour.
Unfortunately, Schelling also noted that if many players attempt the same tactic (tying
the hands of their negotiators) then an impasse is likely. Given how low trade ministries
tend to be in the pecking order of most governments—certainly lower than many
countries’ agricultural ministries, which frequently have an opposing stake in any Doha
2 Trade negotiators like doing deals; it is good for their professional reputations. Just take a look at the webpages of a former senior trade negotiator that has moved into the private sector.
Rethinking Global Economic Governance in Light of the Crisis
114
Round outcome—and given the speed with which information on negotiating positions
can be transmitted back to national capitals, these factors alone may contribute to the
following features observed during the Doha Round: trade negotiators from leading
jurisdictions signal their willingness to negotiate,3 but when the focus is on particularly
sensitive sectors (like agriculture) and more information is revealed about the true
nature of domestic political constraints, then suddenly negotiating flexibility shrivels,
and an impasse results.
Moreover, prime ministers and presidents are well aware of their own negotiator’s
limited mandates (imposed because of strong domestic constituencies), suspect or infer
that other heads of government have imposed similarly restrictive negotiate mandates,
and, unless presented with compelling pressures to the contrary, sustain the status
quo. Consequently, such heads of government resist the elevation of Doha Round
negotiations to international forums, such as the G20. National constraints are projected
on to the international negotiation, in a manner that Schelling foresaw and some trade
negotiators openly acknowledged. Speaking in Washington, DC in 2005, the then-EU
Trade Commissioner Peter Mandelson said:
“I do not underestimate the constraints imposed by domestic politics on both sides
of the Atlantic but we have a wide set of joint interests in the Doha Round. At
the end of the day, we are two very large Continental players with different, but
similar economic structures and specialisations. We should not be in the business
of pre-cooking and imposing outcomes. But it is essential that we work to build
common or coordinated policy platforms. If we cannot agree on basic approaches
then nothing will happen. It’s as simple as that.” (Mandelson 2005).
3 After all, no negotiator wants to exclude themselves from a major negotiation by admitting they can give little or nothing.
The Doha Round impasse
115
Why can’t the limited negotiating mandates be overcome?
Arguing that interests opposed to foreign competition have limited the mandates of
trade negotiators is, at best, only part of the explanation for the Doha Round impasse.
What must also be explained is why the potential beneficiaries of Doha Round accords
were not able or willing to counter the opponents. Several structural explanations follow
and all but the final two can be found in Evenett (2007a, b).
• First, an important source of commercial support for the Doha Round never came
about because negotiations over stronger rules and greater market openness in serv-
ice sectors did not take off.
Here, a less appreciated factor is that the service sector negotiating mandates of many
countries’ trade officials are influenced—if not outright determined—not just by
incumbent firms, but also by independent national service sector regulators, many of
whom resist the restriction on their freedom often implied by binding multilateral trade
accords.
It may be the case that “national politics” was taken out of national regulation through
the creation of independent regulators, but it does not imply that these regulators
are cosmopolitan in outlook. With service sector reform effectively taken out of the
negotiating set, along with the removal of almost all of the Singapore issues in 2004, the
principal remaining negotiating trade-off was agricultural trade reform (in industrialised
countries) in return for greater access to manufactured goods markets (in developing
countries). This was the basis upon which any deal had to be based.
• Second, several factors diminished the value that representatives from industrialised
countries attached to offers to open up manufacturing goods markets in developing
countries.
Before the global financial crisis, with the exception of the United States and Japan,
industrialised countries experienced export growth rates faster than those seen during
the Uruguay Round negotiation. The incremental export growth expected from the
Rethinking Global Economic Governance in Light of the Crisis
116
offers made in Doha Round were perceived as relatively small and, in the eyes of some
leading exporters, not worth fighting for.
• Third, with the exception of China, all the developing countries with large markets
have engaged in enough unilateral tariff reform since the conclusion of the Uruguay
Round that their maximum allowed tariffs (bound tariffs) exceed their applied tariff
rates, on average (Evenett 2007a).
Contrary to much economic thinking about the uncertainty-reducing benefits of tariff
bindings, leading European and American associations of manufacturers and exporters
argued that the unilateral tariff reductions in developing countries were irreversible and
that “binding” tariffs at existing applied levels would generate no additional commercial
benefits.
Only if large developing countries agreed to accept bindings on their tariffs below
existing applied rates would enough market opportunities for industrialised country
exporters be created, it was argued. For the largest developing countries, the latter
would typically amount to a 60–70% cut in the bound rate, a percentage cut nearly
double the rate seen in previous multilateral trade rounds. Developing countries insisted
that the demands made of them were excessive and pointed out that the same logic was
not accepted by industrialised countries in agricultural negotiations where, for many
commodities, applied subsidy levels currently stand well below bound subsidy levels.
• Fourth, the impressive expansion in the share of world exports supplied by the Chi-
nese during the past decade fuelled fears in many countries—both developing and
industrialised—that any tariff cuts on manufacturers would predominately benefit
Chinese exporters.
The fear was that this would intensify import competition even further, and threaten
jobs.
The sustained Chinese export surge also led to pessimism among other nations’
exporters about the prospects of holding on to their overseas market shares. Together,
The Doha Round impasse
117
these factors further skewed the domestic political calculus away from supporting Doha
Round deals that extended benefits to China which, under the Most Favoured Nation
principle, they must.
• Fifth, no mechanism with sharp incentives to bring closure to the Doha Round has
been introduced.
In the Uruguay Round, the larger trading nations made it clear that any reluctance to sign
all of the accords negotiated in 1993 would preclude a country from membership of the
then-to-be-created WTO. Fearing the consequences of becoming second class citizens
in the world trading system, each member of the then-GATT overcame their objections
and signed the Uruguay Round accords. The central prerequisite for employing such
a tactic is agreement on a final accord between the leading trading nations—which
existed in 1992-3 but not in 2011.
Concluding remarks
Ultimately, numerous factors—some of which could not have been anticipated when the
Doha Round was launched in 2001—account for the inability to bring this multilateral
trade negotiation to a successful conclusion. The roots of many of these factors lie
in national political choices including sustained unilateral tariff reforms in many
developing countries, prevailing global economic conditions, the rise of China, and a
lack of a decisive mechanism to stop negotiators from postponing difficult choices to a
later day. If this analysis is correct, it suggests that institutional fixes at the WTO alone
would not have avoided the Doha Round impasse.
The approach taken here represents a marked point of departure from much of the modern
economic literature on the WTO. For nearly 20 years, trade economists have sought to
develop theoretical rationales for the WTO, which are predicated on the assumption
that there is a basis for a deal among negotiating parties. For sure, understanding the
incentives created by WTO accords once nations can agree is important. However, the
principal feature of the Doha Round has not been accord—it has been impasse. More
Rethinking Global Economic Governance in Light of the Crisis
118
research is needed to understand why impasses can arise after a negotiation has begun
with high hopes, what factors and strategies can overturn impasses, and how impasses
themselves may influence subsequent state behaviour.
References
Baldwin, R and S Evenett (eds.) (2011), Why world leaders must resist the false promise
of another Doha delay, VoxEU.org eBook.
Singh Bhatia, Ujal (2011), “Can the WTO be Decoupled From the Doha Round?” in
Next Steps: Getting Past the Doha Round Crisis, Baldwin, R and S Evenett (eds.),
VoxEU.org eBook, 2011.
Evenett, S (2007a), “Doha’s near death experience at Potsdam: why is reciprocal tariff
cutting so hard?” www.voxeu.org. 24 June.
Evenett, S (2007b), “Reciprocity and the Doha Round Impasse: Lessons for the Near
Term and After.” Aussenwirtshaft.
Mandelson, P (2005), “The Right Choices for the Doha Round,” speech at the National
Press Club, Washington DC, 15 September.
Schelling, T (1960), The Strategy of Conflict, Harvard University Press.
The Doha Round impasse
119
About the author
Simon J. Evenett is Professor of International Trade and Economic Development at
the University of St. Gallen, Switzerland, and Co-Director of the CEPR Programme
in International Trade and Regional Economics. Evenett taught previously at Oxford
and Rutgers University, and served twice as a World Bank official. He was a non-
resident Senior Fellow of the Brookings Institution in Washington. He is Member of the
High Level Group on Globalisation established by the French Trade Minister Christine
LaGarde, Member of the Warwick Commission on the Future of the Multilateral Trading
System After Doha, and was Member of the the Zedillo Committee on the Global
Trade and Financial Architecture. In addition to his research into the determinants
of international commercial flows, he is particularly interested in the relationships
between international trade policy, national competition law and policy, and economic
development. He obtained his Ph.D. in Economics from Yale University.
121
The WTO is doing fine when it comes to the 20th century trade it was designed for –
goods made in one nation’s factories being sold to customers abroad. The WTO’s woes
stem from the emergence of “21st century trade” (the complex cross-border flows arising
from internationalised supply chains) and its demand for beyond-WTO disciplines.
The WTO’s centrality was undermined as such disciplines emerged in regional trade
agreements. The future will either see multi-pillar global trade governance with WTO
as the pillar for 20th century trade, or a WTO that engages creatively and constructively
with 21st century trade issues.
1 Introduction
The WTO is widely regarded as trapped in a deep malaise. Exhibit A is its inability to
conclude the multilateral trade negotiations known as the Doha Round, despite 10 years
of talks. This failure is all the more remarkable since it does not reflect anti-liberalisation
sentiments – quite the contrary. The new century has seen massive liberalisation of
trade, investment, and services by WTO members – including nations like India, Brazil,
and China that disparaged liberalisation for decades. WTO members are advancing
the WTO’s liberalisation goals unilaterally, bilaterally or regionally – indeed almost
everywhere except inside the WTO (see Figure 1).
Richard BaldwinGraduate Institute, Geneva and CEPR
The Future of the WTO
Rethinking Global Economic Governance in Light of the Crisis
122
Figure 1. Global trade liberalisation, 1947–2007
13%
12%
10%9%
6%
0%
2%
4%
6%
8%
10%
12%
14%
16%
0
5
10
15
20
25
30
35
40
45
50
1947
1949
1951
1953
1955
1957
1959
1961
1963
1965
1967
1969
1971
1973
1975
1977
1979
1981
1983
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
New RTAs (number of agreements) New WTO members (number of nations) GATT/WTO Round in progress World average tariff (right scale)
Sources: RTAs: WTO online databases & Hufbauer-Schott RTA database; tariffs: Clemson and Williamson (2004) up to 1988, then World DataBank (weighted tariffs all products)
This chapter argues that the WTO is in excellent shape when it comes to the type of
trade it was designed to govern. Indeed, this is why WTO membership remains so
popular (29 new members have joined since 1995). The WTO’s woes stem rather from
the emergence of a new type of trade – call it 21st century trade. This new trade – which
is intimately tied to the unbundling of production – requires disciplines that go far
beyond those in the WTO’s rulebook. To date, virtually all of the necessary governance
has emerged spontaneously in regional trade agreements or via unilateral ‘pro-business’
policy reforms by developing nations. The real threat, therefore, is not failure of the
WTO, but rather the erosion of its centricity in the world trade system.
This line of reasoning suggests the WTO’s future will take one of two forms.
1. The WTO remains relevant for 20th century trade and the basic rules of the road,
but irrelevant for 21st century trade; all ‘next generation’ issues are addressed else-
where.
The Future of the WTO
123
In the optimistic version of this scenario, which seems to be where the current trajectory
is leading us, the WTO remains one of several pillars of world trade governance.
This sort of outcome is familiar from the EU’s three-pillar structure, where the first
pillar (basically the disciplines agreed in treaties up the 1992 Maastricht Treaty) was
supplemented by two new pillars to cover new areas of cooperation.1 In the pessimistic
version of this first scenario, the lack of progress undermines political support and the
WTO disciplines start to be widely flouted; the bicycle, so to speak, falls over when
forward motion halts.
The second scenario involves a reinvigoration of the WTO’s centricity.
2. The WTO engages in 21st century trade issues both by crafting new multilateral dis-
ciplines – or at least general guidelines – on matters such as investment assurances
and by multilateralising some of the new disciplines that have arisen in regional
trade agreements.
There are many variants of this future outlook. The engagement could take the form
of plurilaterals – following the lead of agreements like the Information Technology
Agreement, the Government Procurement Agreement and the like (where only a subset
of WTO members sign up to the disciplines). It could also take the form of an expansion
of the Doha Round agenda to include some of the new issues that are now routinely
considered in regional trade agreements.
In this short essay, I support these conjectures by first discussing why the GATT had so
many wins while the WTO’s had so many woes, then explaining why 21st century trade
emerged and how it is different. Finally, I pull the threads together in the concluding
section.
Note that I straightforwardly ignore many of the standard issues that crop up in essays
about the WTO’s future: the rising number of WTO members and its consensus decision-
1 The pillar structure was removed by the 2009 Lisbon Treaty but its effect was maintained Article by Article.
Rethinking Global Economic Governance in Light of the Crisis
124
making; the rise of new trade giants, especially China, who are both poor and too big
to ignore; the agriculture-manufacturing imbalances in the existing system, etc. In my
view, these are all important, and indeed critical when thinking about how the WTO
should defend its centrality, but I think these factors are less important in understanding
the fundamental sources of the WTO’s difficulties and its options for the future.
2 Why GATT won the war on tariffs
The GATT’s remarkable success in lowering tariffs globally rested on two political
economy mechanisms: the juggernaut effect and the “don’t obey, don’t object” principle.
The juggernaut mechanism draws on a political economy view of tariffs. To put it starkly,
GATT did not work via international cooperation, it worked by rearranging political
economy forces within each nation so that each government found it politically optimal
to lower tariffs. The key is the GATT’s reciprocity principle – “I cut my tariffs if you
cut yours”. This enabled governments to counterbalance import-competing lobbies
(protectionists) with export lobbies (who do not care directly about domestic tariffs,
but who know they must fight domestic protectionists to win better foreign market
access). In short, reciprocity switched each nation’s exporters from bystanders to pro-
trade activists. This made every government more interested in lowering tariffs than
they were before the reciprocal talks started.
Liberalisation continued over the decades, since each set of reciprocal tariff cuts
created political economy momentum. That is, a nation’s own cuts downsized its
import-competing industries (weakening protectionist forces) and foreign cuts upsized
its exporters (strengthening pro-liberalisation forces). In this way, governments found
it politically optimal to further reduce tariffs in the next GATT Round (held five to
ten years down the road after industrial restructuring reshaped the political economy
landscape in a pro-liberalisation direction).
The Future of the WTO
125
The second pillar was the fact that developing nations were allowed to free ride on
the resulting rich-nation tariff cuts.2 This is what lets a large, diverse, consensus-based
organisation operate as if it were run by a small group of self-appointed, like-minded
big economies. Countries whose markets were too small to matter globally – mainly
the developing nations in the GATT decades – were not expected to cut their own tariffs
during Rounds.3 Yet the GATT’s principle of “most favoured nation” (MFN) meant that
their exporters enjoyed the fruits of any tariff-cutting by large economies. Developing
nations had a stake in the success of GATT rounds and nothing to gain from failure. For
developing nations, GATT was a “don’t obey, don’t object” proposition. Of course, this
fudged, rather than solved, the consensus problem.
3 Why GATT magic does not work for WTO
The juggernaut worked exceedingly well in the economies that dominated the trade
system in the 20th century – the so-called Quad (US, EU, Japan and Canada) – and
on the goods of interest to their exporters (mostly manufactures). By the time of the
WTO’s founding in 1995, Quad tariffs were very low on all but a small number of
goods (notably agriculture). The dynamo, however, ran low on fuel as Quad tariffs
fell. To keep exporters interested in fighting protectionists in their national capitals,
the GATT broadened the negotiating agenda for the Uruguay Round (launched in
1986). Guarantees of intellectual property rights, disciplines on the use of investment
restrictions, and the liberalisation of services market were added (known as TRIPs,
TRIMs and Services).4 To balance the agenda, agriculture and textiles barriers were
also added – items that were viewed as being of interest to developing nations.
2 Right from the start, the developed nations were accorded special treatment in the GATT. This became increasingly explicit from the 1956 GATT “review session”; the Haberler Report (1958) provided intellectual backing that eventually led to “special and differential treatment” embodied in the GATT by Article XVIII on Trade and Development.
3 Non-reciprocity happened automatically under the principle-supplier structure of Rounds in the 1940s and 1950s; it became explicit with GATT Article XVIII when formulas began to be used.
4 TRIPs and TRIMs are short for Trade Related Intellectual Property Rights and Trade Related Investment Measures.
Rethinking Global Economic Governance in Light of the Crisis
126
A problem with this agenda-broadening was it was inconsistent with “don’t obey, don’t
object”, which would have allowed developing nations to opt out of TRIPs, TRIMs and
Services disciplines while benefiting from agriculture and textile tariff cuts via MFN.
In short, the consensus problem could no longer be fudged, it had to be solved directly.
The Uruguay Round’s endgame tactics replaced the “don’t obey, don’t object” carrot
with the Single Undertaking stick. That is, the final Uruguay Round package set up a
new institution – the WTO – and made membership a take-it-or-leave-it proposition. All
members, developed and developing alike – even those that had not participated actively
in the negotiations – were obliged to accept all of the Uruguay Round agreements as
one package.5 The old days of developing nation free-riding were over. Refusing to
sign would not cancel a member’s rights under the old GATT, but if the big economies
withdrew, the GATT would be an empty vessel. As history would have it, everyone
joined the WTO. To enforce the Single Undertaking, the flexibility of the GATT’s
dispute settlement procedures was greatly reduced. The new adjudication procedure –
known as the Dispute Settlement Understanding – meant that everyone would have to
obey.
Long story short: the Uruguay Round’s closing tactics unbalanced the GATT’s winning
formula. Developing countries now had to obey, so they would have to object to things
that threatened their interests. The Single Undertaking and hardened dispute settlement
procedure pushed the WTO into decision-making’s “impossible trinity” – consensus,
universal rules, and strict enforcement.6 This is one key reason why the WTO’s Doha
Round is so much more difficult to negotiate than the GATT rounds were.
5 Some developing countries welcomed the Single Undertaking as it reduced their marginalisation in the rule-making avoiding outcomes like the Tokyo-Round Codes.
6 Inspired by Mundell’s exchange-rate trilemma, Ostry (1999) proposed a ‘trade trilemma’ that Rodrik (2000, 2002) made rigorous.
The Future of the WTO
127
4 The nature of international commerce changes: Production unbundling
Without the GATT’s winning formula, one might have expected trade liberalisation to
grind to a halt. It did not. The reason is that world trade and the politics of liberalisation
changed radically in the 1990s. The cause was the information and communication
technology (ICT) revolution, but understanding this requires some background.
4.1 Globalisation as two unbundlings
Globalisation is often viewed as driven by the gradual lowering of natural and man-
made trade barriers. This is a serious misunderstanding. Globalisation made a giant
leap when steam power slashed shipping costs; it made another when ICT decimated
coordination costs. These can be called globalisation’s first and second unbundlings.
Consider the 1st unbundling.
When clippers and stage coaches were high-tech, few items could be profitability
shipped internationally. Production had to be nearby consumption; each village made
most of what it consumed. Steam power changed this by radically lowering transport
costs. The result was ‘the first unbundling’, i.e. the spatial unbundling of production
and consumption. GATT rules where designed to provide the international disciplines
necessary to underpin this sort of trade, i.e. goods that were made in one nation being
sold to customers in another nation.
The first unbundling, however, created a paradox – production clustered into factories
even as it dispersed internationally. The paradox is resolved with three points: (i) cheap
transport favours large-scale production, (ii) such production tends to be very complex,
and (iii) proximity lowers the cost of coordinating complexity. Think of a stylised
factory with several production bays. Coordinating the manufacturing process demands
continuous, two-way flows among bays of things, people, training, investment, and
Rethinking Global Economic Governance in Light of the Crisis
128
information. Productivity-enhancing changes keep the process in flux, so the flows
never die down.
Some of proximity’s cost-savings are related to communications. As the ICT revolutions
loosened the “coordination glue”, it became feasible to spatially separate some types of
production stages, i.e. to spatially unbundle the factories. Since some production stages
were labour intensive, rich-nation firms reduced costs by offshoring them to low-wage
nations. This was the second unbundling.7
The second unbundling transformed international commerce for a very simple
reason. Offshoring internationalised the two-way flows among production bays – the
things, people, training, investment, and information mentioned above. Quite simply,
international commerce became much more complex and diverse, creating ‘21st
century trade’. The heart of this new commerce is what I call the “trade-investment-
services-intellectual property” nexus.8 Specifically, the nexus reflects the intertwining
of (i) trade in parts and components, (ii) international movement of investment in
production facilities, key technical and managerial personnel, training, technology,
and long-term business relationships, and (iii) demand for services to coordinate the
dispersed production.
In the 20th century, the trading system was mostly important on the ‘demand side’; it
was about helping firms sell abroad products they made at home. In the 21st century, it
is also important on the ‘supply side’, helping firms produce goods quickly and cheaply
with international supply chains.
7 See, for example, Ando and Kimura (2005), Kimura, Takahashi, and Hayakawa (2007), Gaulier, Lemoine and Unal-Kesenci (2007), and Athukorala (2005) in the East Asian case, and Federal Reserve Bank of Dallas (2002) or Feenstra and Hanson (1997) on the North American case.
8 See Baldwin (2011).
The Future of the WTO
129
4.2 The nature of trade barriers and trade policies changes
Emergence of the trade-investment-services-IP nexus meant that trade now involved
two new necessities – connecting factories, and doing business abroad. Underpinning
these involved rules on things that were never considered trade issues in the GATT era.
1. Connecting factories involves assurances on business-related capital flows, world-
class telecoms, air cargo, overnight parcel services, customs clearance services,
short-term visa for managers and technicians, and infrastructure (ports, road, rail
and electricity reliability, etc.). Of course, tariffs and other border measures also
matter.
2. Doing business abroad involves a whole range of formerly domestic policies – so-
called behind-the-border barriers such as competition policy, property rights, rights
of establishment, the behaviour of state-owned enterprises, the protection of intel-
lectual property, and assurances on investor rights. All of these are important to
doing business abroad.
In this new world, any policy that hinders the nexus is now a trade barrier.
The second unbundling created a de novo impulse for liberalisation – developing nations
wanted the offshored industrial jobs and technology, rich-nation firms wanted access
to lower-cost labour. Both pushed for disciplines to underpin the trade-investment-
services-IP nexus. The result was “deep” regional trade agreements and unilateral pro-
business reforms by developing nations. The result can be seen in Figure 1 – the WTO’s
difficulty with the Doha Round did nothing to slow global trade liberalisation.
The political economy of liberalisation also changed. It was no longer the juggernaut’s
“I’ll open my market if you open yours”, but became a reciprocal deal based on “foreign
factories for domestic reforms”. Developing nations were willing to reform all sorts of
behind-the-border barriers in exchange for factories and industrial jobs that came from
joining a rich-nation’s supply chain.
Rethinking Global Economic Governance in Light of the Crisis
130
The WTO’s centrality suffered. As there are no factories on offer in Geneva, the new
rule-writing shifted to bilateral deals. If a developing nation wants US, EU, or Japanese
factories, they talk directly with Washington, Brussels, or Tokyo.
Of course, 20th century trade is still with us, and is important in some goods (e.g.
primary goods) and for some nations (international supply chains are still rare in Latin
American and Africa), but the most dynamic aspect of trade today is the development
of international value chains.
5 Concluding remarks
When it comes to 20th century trade and trade issues, the WTO is in rude health.
• The basic WTO rules are almost universal respected.
• The decisions of the WTO’s court are almost universally accepted.
• Nations – even big, powerful nations like Russia – seem willing to pay a high politi-
cal price to join the organisation.
• The global crisis created protectionist pressures, but most of the new protection
conformed to the letter of the WTO law (Evenett 2011).
In short, the WTO is alive and well when it comes to the types of trade and trade
barriers it was designed to govern, i.e. 20th century trade (the sale of goods made in
factories in one nation to customers in another).
Where the WTO’s future seems cloudy is on the 21st century trade front. The demands
for new rules and disciplines governing the trade-investment-services-IP nexus are
being formulated outside the WTO. Developing nations are rushing to unilaterally
lower their tariffs (especially on intermediate goods) and unilaterally reduce behind-
the-border barriers to the trade-investment-services-IP nexus. All of this has markedly
eroded the WTO centrality in the global trade system.
The Future of the WTO
131
The implication of this is clear. The WTO’s future will either be to stay on the 20th
century side-track on to which it has been shunted, or to engage constructively and
creatively in the new range of disciplines necessary to underpin 21st century trade.
References
Ando, Mitsuyo and Fukunari Kimura (2005), “The Formation of International Production
and Distribution Networks in East Asia,” in T. Ito and A. Rose (eds) International Trade
in East Asia, NBER-East Asia Seminar on Economics, Volume 14, pp 177-216.
Baldwin, Richard (2011), “21st Century Regionalism: Filling the gap between 21st
century trade and 20th century trade rules”, CEPR Policy Insight No. 56, London:
CEPR.
Clemens, Michael A. and Jeffrey G. Williamson (2004), “Why Did the Tariff-Growth
Correlation Change after 1950?“, Journal of Economic Growth 9(1), 5-46.
Evenett, Simon (2011), “Did the WTO Restrain Protectionism During The Recent
Systemic Crisis?”, www.globaltradealert.org.
Federal Reserve Bank of Dallas (2002), “Maquiladora Industry: Past, Present and
Future”, Issue 2.
Feenstra, Robert and Gordon Hanson (1997), “Foreign direct investment and relative
wages: Evidence from Mexico’s maquiladoras,” Journal of International Economics
42(3-4), 371-393.
Gaulier, Guillaume, Francoise Lemoine and Deniz Unal-Kesenci (2007), “China’s
emergence and the reorganisation of trade flows in Asia,” China Economic Review
18(3), 209-243.
Haberler, Gottfried (1958), “Trends in International Trade, Report of a Panel of
Experts”, Geneva: GATT Secretariat.
Rethinking Global Economic Governance in Light of the Crisis
132
Kimura, Fukunari, Yuya Takahashi, and Kazunobu Hayakawa (2007), “Fragmentation
and parts and components trade: Comparison between East Asia and Europe”, The
North American Journal of Economics and Finance 18(1), 23-40.
Ostry, Sylvia (1999), “The Future of the WTO”, Brookings Trade Forum, edited by
Dani Rodrik and Susan Collins, Washington, DC: Brookings Institution.
Athukorala, Prema-chandra (2006), “Multinational Production Networks and the New
Geo-economic Division of Labour in the Pacific Rim,” Departmental Working Papers
2006-09, Australian National University, Arndt-Corden Department of Economics.
Rodrik, Dani (2000), “How Far Will International Economic Integration Go?” Journal
of Economic Perspectives 14(1), 177–186.
Rodrik, Dani (2002), “Feasible Globalizations”, NBER Working Paper 9129.
The Future of the WTO
133
About the author
Richard Edward Baldwin is Professor of International Economics at the Graduate
Institute, Geneva since 1991, Policy Director of CEPR since 2006, and Editor-in-Chief
of Vox since he founded it in June 2007. He was Co-managing Editor of the journal
Economic Policy from 2000 to 2005, and Programme Director of CEPR’s International
Trade programme from 1991 to 2001. Before that he was a Senior Staff Economist for
the President’s Council of Economic Advisors in the Bush Administration (1990-1991),
on leave from Columbia University Business School where he was Associate Professor.
He did his PhD in economics at MIT with Paul Krugman. He was visiting professor at
MIT in 2002/03 and has taught at universities in Italy, Germany and Norway. He has
also worked as consultant for the numerous governments, the European Commission,
OECD, World Bank, EFTA, and USAID. The author of numerous books and articles, his
research interests include international trade, globalisation, regionalism, and European
integration. He is a CEPR Research Fellow.
135
To policymakers in most nations, there is a world of difference between trade and
migration policies. The theoretical literature in economics, by contrast, has focused on
their similarities (Mundell 1957). In standard trade models, liberalising trade in goods
and removing barriers to labour (or capital) mobility is beneficial for world welfare
– when goods move freely across borders, countries can gain by exporting what they
produce more efficiently and importing what other nations produce at a lower price.
Likewise, all countries can gain if migration barriers are removed between them, so that
workers from low-pay nations can move and earn higher wages, and employers in the
high-wage country can hire foreign workers at a lower cost.
More specifically, the theory argues that if the only difference between countries lies
in their relative labour abundance, commodity trade and labour mobility are substitutes
(Razin and Sadka 1997). Freer trade should lead poorer countries to specialise in the
production of labour-intensive goods. In turn, this should lead to a rise in wages of
unskilled workers, decreasing their incentives to move abroad. Trade liberalisation
should then decrease the need for labour migration. This argument was often raised
during the negotiations of the North American Free Trade Agreement (NAFTA).
Policymakers argued that the agreement would allow Mexico to export “goods and not
people” (Fernández-Kelly and Massey 2007).
Paola Conconi, Giovanni Facchini, Max F Steinhardt, and Maurizio ZanardiUniversité Libre de Bruxelles (ECARES) and CEPR; Erasmus University Rotterdam, Universita’ degli Studi di Milano ,and CEPR; Hamburg Institute for International Economics; Université Libre de Bruxelles (ECARES)
Open to goods, closed to people?
Rethinking Global Economic Governance in Light of the Crisis
136
Why are policy attitudes so different?
If labour migration and international trade have similar implications for global efficiency
and factor markets, why are immigration policies so much more restrictive than trade
policies? Through successive rounds of negotiations, average industrial tariffs rates
around the world have fallen steadily since WWII. By contrast, immigration policies
have remained tight and, in many countries, they have become tighter (Faini 2002,
Hatton 2007). As a result, many economists argue that potential gains from more open
labour migration dwarf those from freer trade. As Dani Rodrik puts it, “the gains from
liberalising labour movements across countries are enormous, and much larger than the
likely benefits from further liberalisation in the traditional areas of goods and capital. If
international policymakers were really interested in maximising worldwide efficiency,
they would spend little of their energies on a new trade round or on the international
financial architecture. They would all be busy at work liberalising immigration
restrictions” (Rodrik 2002, p. 314).
However, unless we have a better understanding of why trade and migration policies
differ so much, it is difficult to know whether migration reforms are likely to be
successful. If the gains from liberalising international migration generate such large
worldwide gains, why does migration lag so far behind international trade in terms of
permissible mobility?
To address this question, we examine the determinants of the voting behaviour of
US legislators on all major trade and migration reforms voted in Congress during
the period 1970-2006. In terms of trade reforms, we include in all our analysis votes
on the implementation of multilateral trade agreements (Tokyo and Uruguay Round
rounds of the GATT) and preferential trade agreements (e.g. the Canada-US Free Trade
Agreement and NAFTA) negotiated in this period, as well as the votes on the conferral
and extension of fast track trade negotiating authority to the president, which makes
Open to goods, closed to people?
137
it easier to negotiate trade agreements (see Conconi, Facchini and Zanardi 2012).1 In
terms of migration votes, they include two different categories: general immigration
and illegal migration (see Facchini and Steinhardt 2011), and we restrict the analysis to
those that have a direct (positive or negative) impact on the size of the unskilled labour
force in the US.
We match House roll call voting data on trade and migration reforms with information
about legislators’ names, states and congressional districts, which enables us to uniquely
identify the legislators and link them to their constituency. We also collect systematic
information about the representatives (e.g. party affiliation, age, gender, incumbency
gains as well as on economic and non-economic characteristics of their constituencies
(e.g. skill composition, fiscal burden of immigrants, percentage of foreign-born
population).
From a methodological point of view, we first run probit regressions on the full sample
of votes, studying the determinants of individual legislators’ decisions on trade and
migration reforms. We then focus our analysis on a subsample of trade and migration
reforms that have taken place during the same Congress. This allows us to control for
unobserved characteristics of legislators, which might affect their voting behaviour on
trade and migration bills. Finally, we estimate bivariate probit regressions, allowing
legislators’ decisions on trade and migration to be interrelated.
Emprical results
Our empirical analysis shows both similarities and differences in congressmen’s voting
behaviour on these policy issues. In line with the predictions of standard international
trade models, we find that a constituency’s skill composition affects representatives’
voting behaviour on trade and migration liberalisation bills in the same direction. In
1 Previous studies trying to understand differences between trade and migration policies have used surveys of individuals’ opinions on these issues (e.g., Hanson, Scheve and Slaughter, 2007; Mayda, 2008). Ours is the first study to focus on actual policy choices by legislators.
Rethinking Global Economic Governance in Light of the Crisis
138
particular, representatives of districts with relatively more highly skilled labour are
more likely to support liberalising unskilled migration as well as trade with labour-
abundant countries. Party affiliation has instead opposite effects – Democrats are more
likely to support liberal immigration policies but to oppose trade liberalisation.
Voting differences between the two issues are also driven by districts’ characteristics
that affect decisions on immigration policy but do not influence the voting behaviour
on trade.
• We find that the higher the fiscal burden of immigrants for a constituency, the less
likely the representative of the constituency is to support liberal migration policies.
This is in line with previous studies showing that one of the reasons for the opposition
to immigration is the concern that admitting low-skilled foreigners raises the net tax
burden on US natives (Hanson, Scheve and Slaugther 2007, Facchini and Steinhardt
2011).
• Districts’ ethnic composition also affects voting behaviour on immigration reforms
– support for these reforms increases with the share of foreign-born citizens in a
constituency.
This finding confirms the importance of network effects, which has been emphasised in
recent studies (e.g. Munshi 2003).
Our study can help to explain the gap between the global regulation of labour migration
and that of trade flows. In line with standard international trade models, our empirical
analysis suggests that trade and migration have parallel impacts on factor markets.
However, the flow of human beings has political, cultural, social, and economic effects
that clearly differ from those from the flow of goods. These effects can explain why
legislators are more likely to support opening barriers to goods than to people.
Open to goods, closed to people?
139
References
Conconi, P., G. Facchini, and M. Zanardi (2012). “Fast Track Authority and International
Trade Negotiations”, American Economic Journal: Economic Policy, forthcoming.
Facchini, G., and M. F. Steinhardt (2011). “What Drives US Immigration Policy?,”
Evidence from Congressional Roll Call Votes”, Journal of Public Economics 95, 734-
743.
Fernández-Kelly, P., and D. S. Massey (2007). “Borders for Whom? The Role of
NAFTA in Mexico-US Migration”, Annals of the American Academy of Political and
Social Science 610, 98-118,
Hanson, G. H., K. Scheve, and M. J. Slaugther (2007). “Public Finance and Individual
Preferences over Globalization Strategies”, Economics and Politics 19, 1-33.
Hatton, T. J. (2007). “Should We Have a WTO for International Migration?” Economic
Policy 22, 339-383.
Faini, R. (2002). “Development, Trade, and Migration”, Revue d’Économie et du
Développement, Proceedings from the ABCDE Europe Conference, 1-2: 85-116.
Mayda, A. (2008). “Why are People more pro Trade than pro Migration?” Economics
Letters 101, 160-163.
Mundell, R. (1957). “International Trade and Factor Mobility”, American Economic
Review 47, 321-335.
Munshi, K. (2003). “Networks in the Modern Economy: Mexican Migrants in the US
Labor Market”, Quarterly Journal of Economics 118, 549-599.
Razin, A., and E. Sadka (1997). “International Migration and International Trade”, in
Handbook of Population and Family Economics 1, 851-887.
Rethinking Global Economic Governance in Light of the Crisis
140
Rodrik, D. (2002). “Comments at the Conference on Immigration Policy and the
Welfare State”, in Boeri, T., G. H. Hanson, and B. McCormick (eds.), Immigration
Policy and the Welfare System, Oxford University Press.
About the authors
Paola Conconi holds is a B.A. in Political Science from the University of Bologna, an
M.A. in International Relations from the School of Advanced International Studies of
Johns Hopkins University, and a M.Sc. and a Ph.D. in Economics from the University
of Warwick. Her main research interests are in the areas of international trade,
international migration, regional integration and political economy. Her contribution
to the project will be on governance of trade institutions, on which she has published
various papers in international journals such as the Journal of International Economics
or the Journal of Public Economics.
Giovanni Facchini is a Professor of Economics at Erasmus University Rotterdam and
at the University of Milan, having taught previously at the University of Essex, the
University of Illinois at Urbana Champaign and at Stanford. His research focuses on
international trade and factor mobility. He has published in journals such as the Journal
of the European Economic Association, the Review of Economics and Statistics, the
Journal of International Economics, the Journal of Public Economics, among others.
Giovanni is a CEPR Research Affiliate, a fellow of CES-Ifo and IZA, and a Faculty
Affiliate at the Institute for Government and Public Affairs at the University of Illinois-
Urbana Champaign. He coordinates research on international migration at the Centro
Studi Luca d’Agliano in Milan. He obtained a PhD in Economics from Stanford
University in 2001.
Max Friedrich Steinhardt is a Senior Researcher in “Demography, Migration and
Integration” at the Hamburg Institute of International Economics (HWWI). His
research interests lie in the fields of labour economics, economics of migration,
applied microeconometrics and regional economics. He studied economics at the
Open to goods, closed to people?
141
University of Hamburg. 2009 he finished his doctoral dissertation with a thesis about
the economics of migration. Within the TOM Marie Curie Training Networks Dr. Max
Friedrich Steinhardt stayed at the Centro Studio Luca D’Agliano (LdA) in Milan and at
the European Center for Advanced Research in Economics and Statistics (ECARES) in
Brussels. Furthermore, he worked as an external consultant for the OECD.
Maurizio Zanardi is an Associate Professor of Economics at the Universite Libre de
Bruxelles and a member of ECARES. His research interests include international trade
and political economy. He received his PhD in Economics from Boston College and
BA in Economics from the Catholic University of Milan.
143
Introduction
The current recession, concentrated in Europe and North America, has raised questions
about immigration policy. When labour markets are slack, attitudes towards immigrants
become more negative, the case for keeping the door ajar gets weaker, and political
imperatives for tougher immigration policy get stronger. Yet in the current recession,
anti- immigration policy has been muted – and all the more so when compared with
the past.
This chapter draws on historical experience to answer four questions.
• How flexible is the response of migration to the business cycle?
• Do immigrants bear a disproportionate burden in recessions?
• What drives public opinion on immigration, especially at times of recession?
• How does immigration policy respond in recessions and why is it different this
time?
Recessions and immigration — past and present
International migration has always been sensitive to the ebb and flow of the business
cycle.1 This was so in the 19th century and it remains true today. If immigrants are
deterred by high unemployment and existing migrants go home, then such responses
1 See, for example, Özden et al (2011).
Timothy J HattonAustralian National University, University of Essex, and CEPR
The recession and international migration
Rethinking Global Economic Governance in Light of the Crisis
144
may attenuate labour market competition and mute the clamour for restriction. But is
that migration response more or less elastic in the present than in the past?
In the great European migrations of the late 19th century, when immigration policies
were vastly less restrictive than today, migration flows were very volatile (Hatton and
Williamson 1998). The effects of unemployment at home and abroad can be seen
clearly for emigration from the UK from 1870 to 1913. Analysis shows that fluctuations
in home unemployment had smaller effects on emigration than unemployment abroad.
Return migration was also influenced by host country labour market conditions and so
net emigration was even more cyclically sensitive than gross migration (Hatton, 1995).
In the slump of the early 1890s, gross immigration to the US fell by half and net
immigration to the US, Canada, and Australia fell even more dramatically as previous
immigrants headed for home (Hatton and Williamson 1998). The same thing happened
again in the Great Depression – in the US, net migration turned negative as outflows
exceeded inflows.
How big are these effects? Where immigration policies are not too restrictive, history
tells us that every 100 jobs lost in a high-immigration country results in 10 fewer
immigrants. This 10% rule described countries like Canada and Australia in the Great
Depression, and it worked pretty well for other periods too. For countries of emigration,
recession worked in the opposite direction – as the global depression deepened, their
labour markets became even more glutted as fewer left and more returned.
How do recent times compare? For the US over the period 1990 to 2004, the 10% rule
still applies. For example, unemployment rose by about one percentage point between
1997 and 2000 and net immigration fell by one per thousand of the US population.
Between 2000 and 2002, immigration recovered as employment fell (Hatton and
Williamson 2009). For the EU27 in the current recession the same pattern re-emerges,
in a slightly muted form. From 2008 to 2010, the EU-wide unemployment rate rose
from 7.2% to 9.0% and net migration fell from 2.6 to 1.4 per thousand.
The recession and international migration
145
The overall EU-wide fluctuation in unemployment is relatively small, but what about
the countries that have been hardest hit by the recession? Figure 1 shows the relationship
between the unemployment rate and gross immigration in Ireland and Spain. For
Ireland, the steep rise after 2004 was mainly due to immigration from the A8 accession
countries (Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Slovakia, and
Slovenia). The classic relationship between unemployment and immigration is clearly
visible in the recession, however, and it would be even stronger for net immigration, as
out-migration from both countries doubled between 2007 and 2009 (Papademetriou et
al. 2010)
Figure 1. Gross immigration per thousand and unemployment percentage
0.0
5.0
10.0
15.0
20.0
25.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Spain
I Rate U rate
0.0
5.0
10.0
15.0
20.0
25.0
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Ireland
I Rate U Rate
Source: OECD StatExtracts at: http://stats.oecd.org/Index.aspx
Thus, the responsiveness of immigration to the business cycle has remained at about
its historical level, despite the fact that policy is much more restrictive than it was (at
least for the Atlantic economy) in the 19th century. On the other hand, transport costs
are lower and there are many channels of entry such as temporary worker schemes and
illegal immigration. Even the numbers of family reunification migrants and asylum
seekers are influenced by economic conditions.
Rethinking Global Economic Governance in Light of the Crisis
146
Immigrants in the labour market
One reason why immigration slows down in a recession is that immigrants typically
do badly in the labour market as unemployment increases. Table 1 shows that
unemployment rates among immigrants are typically much higher than for nationals.
As unemployment increases, the ratio of unemployment rates of immigrants to natives
remains remarkably stable (except in Greece). This means that the difference in
unemployment rates (and hence in employment probabilities) between immigrants and
natives increases.
Table 1. Unemployment rates in western Europe
Male unemployment 2008 Male unemployment 2010
Native Foreign F/N Native Foreign F/N
Austria 2.9 3.8 1.3 7.3 8.8 1.2
Belgium 5.3 6.7 1.3 14.3 17.5 1.2
Germany 6.6 7.0 1.1 12.3 12.6 1.0
Demark 2.7 7.7 2.8 6.4 15.1 2.4
Spain 8.8 17.3 2.0 16.4 31.1 1.9
Finland 5.9 9.2 1.6 12.4 18.9 1.5
France 6.3 8.4 1.3 11.4 13.6 1.2
Great Britain 6.1 8.8 1.4 6.8 9.2 1.4
Greece 5.2 8.8 1.7 5.0 14.7 2.9
Ireland 7.0 16.5 2.3 8.2 19.2 2.3
Italy 5.6 7.3 1.3 5.9 9.7 1.6
Netherlands 2.1 3.8 1.8 5.3 8.5 1.6
Norway 2.4 3.5 1.4 6.0 9.8 1.6
Portugal 6.8 10.2 1.5 7.8 12.7 1.6
Sweden 5.1 7.4 1.4 11.5 15.9 1.4
Source: OECD StatExtracts at http://stats.oecd.org/Index.aspx
The impression from Table 1 is supported by detailed analysis. For the UK and
Germany, Dustmann et al. (2010) find that unemployment is more strongly cyclical for
immigrants than for natives, and especially for immigrants from outside the OECD.
Partly, this reflects differences in skill levels but even within skill groups, immigrants are
The recession and international migration
147
more vulnerable to changes in unemployment than non-immigrants. Thus immigrants
are classic ‘outsiders’ – they have lower levels of tenure, often on insecure contracts,
and are more concentrated than natives in cyclically sensitive sectors and age groups
(Papademetriou et al. 2010).
So immigrants cushion the effects of recession on native workers for two reasons. Some
of them go home (or decide not to come) and those who remain shoulder more of the
burden of unemployment.
Public opinion towards immigrants
It is well known that popular opinion is, on the whole, anti-immigration. Table 2 provides
evidence from the European Values Survey for 2008 (the most recent available).
The first five columns of numbers are the average of responses arranged on a scale
where ten is complete agreement with the statement and one is complete disagreement.
Hence a neutral score would be 5.5. The first three columns show that, while average
opinion is fairly neutral on the issue of whether immigrants undermine the cultural life
of a society, it is rather more negative on whether immigrants are a threat to society and
even more so on whether immigrants worsen the problem of crime.
The next two columns indicate that, while people are broadly neutral on whether
immigrants take away jobs, they tend to be somewhat more negative on whether
immigrants impose a welfare burden. The final column is on a scale where five is total
agreement with the statement that there are ‘too many immigrants’ and one is total
disagreement. Hence a neutral score would be 3.0. For 14 out of 16 countries, the score
is at least three but less than four. While these figures conceal widely divergent views,
opinion is negative on average, but not extremely so.
Rethinking Global Economic Governance in Light of the Crisis
148
Table 2. Public opinion on immigration in western Europe, 2008
Undermine cultural
life
Threat to society
Make crime worse
Take jobs away
Strain on welfare
Too many immigrants
Austria 6.4 6.7 7.6 6.4 7.5 3.7
Belgium 5.7 6.6 6.7 5.8 6.9 3.6
Denmark 4.5 5.5 7.2 3.1 6.6 2.7
Finland 4.0 5.8 6.9 4.9 6.5 3.0
France 5.0 5.8 5.2 4.7 6.1 3.2
Germany 6.0 6.4 7.5 6.4 7.6 3.4
Greece 5.5 7.0 7.3 6.7 6.7 4.4
Ireland 5.8 6.7 6.3 6.8 7.5 3.7
Italy 4.9 6.1 7.3 5.4 6.1 3.6
Netherlands 5.2 5.9 6.7 5.3 6.1 3.1
Norway 4.9 5.9 7.4 4.3 6.9 3.0
Portugal 4.7 5.8 6.2 6.3 6.0 3.3
Spain 4.9 5.6 6.3 5.7 5.5 3.6
Sweden 4.3 5.0 6.3 3.9 5.6 3.0
Switzerland 5.0 5.6 7.0 4.9 6.7 3.2Great Britain
6.4 7.2 6.5 6.8 7.6 3.8
Source: European Values Study 2008 at http://zacat.gesis.org/webview/.
Detailed analysis of public opinion often reveals that negative sentiment towards
immigration is strongest among those with low education, among males and older
people, and among those that are not themselves first or second generation immigrants.
Those with higher levels of education have greater tolerance towards minorities and
are more positive about ethnic and cultural diversity (Dustmann and Preston 2007,
Hainmueller and Hiscox 2007). They are also less likely to be concerned about the
potential labour market competition from low-skilled immigrants (Mayda 2006,
O’Rourke and Sinnott 2006).
Consistent with the figures in Table 2, recent studies have also pointed to the importance
of concerns about the fiscal cost of immigration (Facchini and Mayda 2009, Boeri
2010). In particular, they point to fears that higher immigration will lead to a higher tax
burden. Boeri (2010) finds that the net fiscal contribution of immigrants is positive for
The recession and international migration
149
some EU countries but is more likely to be negative where there is a higher proportion
of low-skilled immigrants. The evidence also suggests that opinion is more negative the
greater the fiscal drain (Boeri 2010).
Not surprisingly, some studies also suggest that the scale of immigration is an important
determinant of negative attitudes, either at the aggregate level (Lahav 2004) or as a
result of concentration in the respondent’s local community (Dustman and Preston
2001). Even before the current recession, public opinion became more negative in
countries such as Ireland and Spain as the number of immigrants surged. In Spain, the
proportion of respondents in the World Values Survey wanting immigration prohibited
or strictly limited rose from 28% in 1995 to 44% in 2008.
What do such studies say about long-run trends in popular opinion? There are forces
in both directions. Over the long run, average education has strongly increased (which
should reduce anti-immigrant sentiment) but so has the share of immigrants. For the US
(the only available long-run series), the proportion wanting immigration reduced has
decreased on trend since the 1980s (Hatton and Williamson 2009). In the short run, as
noted earlier, the fall in net immigration and the increased immigrant unemployment
burden has cushioned the effect of the recession on the native employment. But on the
other hand, the increase in immigrant welfare dependency has worked in the opposite
direction. This last effect is likely to be all the more important when budget deficits are
large and fiscal austerity is headline news.
Immigration policy: Past and present
History suggests that recessions have sometimes been occasions for the introduction
of restrictive immigration policy; sometimes but not always. A policy backlash is
more likely, and when it occurs is more draconian, when it follows an extended period
of high immigration. As the stock of migrants increases, popular attitudes become
more negative – the more so the greater are the cultural and socioeconomic differences
between immigrants and non-immigrants. Thus a recession can be the trigger that
Rethinking Global Economic Governance in Light of the Crisis
150
converts growing anti-immigrant sentiment into a decisive tightening of immigration
policy. This process can be illustrated with three historical examples.
In the US, anti-immigrant sentiment was on the rise from the 1880s onwards as the
number of immigrants mounted and more of them came from the then poorer countries
of southern and eastern Europe. After several unsuccessful attempts, starting in the
deep 1890s recession, Congress finally introduced a literacy test in 1917. Labour
market conditions were important (Goldin 1994), and no doubt the First World War
also fostered changing attitudes. But the decisive policy shift came with the Emergency
Quota Act in 1921, which became the basis of immigration policy until the 1960s. The
introduction of quotas occurred just as the unemployment rate rose from 5.2% in 1920
to 11.7% in 1921.
A decade later, the Great Depression saw a rapid retreat from open door immigration
policies in a number of countries including Australia, Canada, Brazil, Argentina, and
Singapore. These reverses occurred in the aftermath of the economic shock and so
they contributed marginally to the downturns in net immigration noted earlier. A third
example comes from Europe in the 1970s. From the late 1950s, a number of countries
(most prominently Germany) adopted guestworker programmes that admitted migrants
from southern and eastern Europe, Turkey, and North Africa. As the number of
immigrants grew and economic growth slowed down, attitudes to immigration soured.
In the early 1970s, rapidly deteriorating economic conditions and the first oil price
shock brought these policies to an abrupt end (Hatton and Williamson 2005).
These historical examples would lead us to expect a sharp turn to restrictive immigration
policies. After all, the global financial crisis was preceded by two decades of rising
immigration to OECD countries, and especially to EU countries. And as we have seen,
the climate of opinion towards immigration was moderately negative even before the
crisis struck. So what has happened?
Observers often point to the rise of right-wing anti-immigration parties and their
influence (either direct or indirect) on immigration policy. Across Europe, such parties
The recession and international migration
151
have raised the salience of immigration policy but, with a few exceptions, their gains
in electoral support predate the global financial crisis. Nevertheless, there have been
some well-publicised policy shifts. These include a sharp shift to restriction on work
permits and student visas in the UK, increased border enforcement measures in France
and Italy, incentives for return migration for unemployed immigrants in Spain, and a
clampdown on immigrant welfare services in Denmark.
However, these must be put into perspective. Tougher rules were imposed in some
countries even before the recession, for example those on family reunification in France
and the Netherlands. And across the OECD, policy on asylum seekers became tougher
for at least a decade before 2007 (Hatton 2011). Although much of the focus has been
on policies towards the integration of immigrants (and sometimes the explicit rejection
of multiculturalism), the Migrant Integration Policy Index (MIPEX) suggests that for
the EU15 there was very little change overall between 2007 and 2011 (MIPEX 2011).
This is partly because some countries have become more generous while others have
become tougher. And even for a single country, different strands of policy often shift in
different directions.
Conclusion
We might expect a deep recession to be the occasion for a sharp tightening of
immigration policies, especially after a long period of rising immigration. So far that
has not happened – at least not a severely as history would lead us to expect. One last
historical comparison is useful – international trade. During the Great Depression and
at other times of severe economic shocks, tariffs and other trade barriers also increased
sharply. In the current recession, some observers have noted the rising use of temporary
trade barriers and policies that restrict trade under other guises (Bown 2011). But
compared with historical experience, the increase in protection has been mild.
With regard to trade, one argument is that seriously protectionist policies are simply not
possible within the WTO framework. The commitment of G20 governments and other
Rethinking Global Economic Governance in Light of the Crisis
152
international leaders to the global trading framework has protected it from a potentially
catastrophic collapse that could have reversed half a century of progress. Such
arguments do not apply with the same force to migration. Although the EU has a range
of directives that set minimum standards on issues such as immigrant employment,
access to welfare, family reunification and asylum policy, these do not apply elsewhere.
Yet even outside the EU, any shift towards restrictive immigration policy has been
muted.
The truth is that we still do not fully understand how immigration policy evolves, and
why it seems so different now than in the past. Nevertheless, we can point to some key
factors.
• With rising education, attitudes to immigration are better informed and there is also
less to fear from the competition of unskilled immigrants.
Thus, with a few exceptions, there is no pre-existing upward trend in anti-immigrant
sentiment overall.
• While people may be concerned with the cost of the welfare state, unlike the more
distant past, it also provides them with a safety net.
• At the international level cooperation has increased, within the EU and beyond, and
draconian immigration rules could potentially be inimical to negotiations on other
issues.
But such arguments must remain speculative until they can be subjected to more
rigorous examination.
The recession and international migration
153
References
Boeri, T. (2010), “Immigration to the Land of Redistribution,” Economica, 77, pp.
651–87.
Bown, C. P. (ed.) (2011), The Great Recession and Import Protection: The Role of
Temporary Trade Barriers, London: CEPR Policy Report.
Dustmann, C. and Preston, I. (2001), «Attitudes to Ethnic Minorities, Ethnic Context
and Location Decisions,” Economic Journal, 111, 353-373.
Dustmann, C. and Preston, I. (2007), “Racial and Economic Factors in Attitudes to
Immigration,” Berkeley Electronic Journal of Economic Analysis and Policy, 7, Article
62.
Dustmann, C., Glitz, A. and Vogel, T. (2010), “Employment, Wages and the Economic
Cycle: Differences between Immigrants and Natives,” European Economic Review, 54,
pp. 1-17.
Facchini, G. and Mayda, A. M. (2009), “Does the Welfare State Affect Individual
Attitudes toward Immigrants?” Review of Economics and Statistics, 91, pp. 295–314.
Goldin. C. D. (1994), “The Political Economy of Immigration Restriction in the United
States,” in C. Goldin and G. Libecap (eds.), The Regulated Economy: A Historical
Approach to Political Economy, Chicago: University of Chicago Press.
Hainmueller, J. and Hiscox, M. J. (2007), “Educated Preferences: Explaining Individual
Attitudes toward Immigration in Europe,” International Organization, 61, pp. 399–442.
Hatton, T. J. (1995) “A Model of UK Emigration, 1871-1913,”Review of Economics
and Statistics, 77, pp. 407-415.
_____ (2011), Seeking Asylum: Trends and Policies in the OECD, London: Centre
for Economic Policy Research, at: http://www.cepr.org/pubs/books/cepr/Seeking_
Asylum.pdf.
Rethinking Global Economic Governance in Light of the Crisis
154
Hatton, T. J. and J. G. Williamson (1998), The Age of Mass Migration: Causes and
Economic Impact, New York: Oxford University Press.
_____ (2005), Global Migration and the World Economy: Two Centuries of Policy and
Performance, Cambridge, Mass.: MIT Press.
_____ (2009)” Global Economic Slumps and Migration” VOX EU at: http://voxeu.org/
index.php?q=node/3512
Lahav, G. (2004), “Public Opinion toward Immigration in the European Union: Does it
Matter?” Comparative Political Studies, 37, pp. 1151–1183.
Mayda, A. M. (2006), “Who Is Against Immigration? A Cross-Country Investigation
of Attitudes towards Immigrants,” Review of Economics and Statistics 88, pp. 510–30.
MIPEX (2011), Migrant Integration Policy Index III, at: http://www.mipex.eu/.
Özden, Ç., C. Parsons, M. Schiff and T. Walmsley (2011), “Where on earth is everybody?
Global migration 1960-2000”, VoxEU.org, 6 August.
O’Rourke, K. H. and Sinnott, R. (2006), ‘The Determinants of Individual Attitudes
towards Immigration’, European Journal of Political Economy, 22, pp. 838–61.
Papademetriou, D. G., Sumption, M. and Terrazas, A. (2010), “Migration and
Immigrants Two Years after the Financial Collapse: Where do we Stand?” at www.
migrationpolicy.org/pubs/MPI-BBCreport-2010.pdf.
The recession and international migration
155
About the author
Tim Hatton is Professor of Economics at the University of Essex and at the Australian
National University. His current research interests include the causes and effects
of international migration, and immigration and asylum policy. He has published
extensively on the economic history of labour markets, including the history of
international migration. His most recent books include Seeking Asylum: Trends and
Policies in the OECD (CEPR, 2011) and (with Jeffrey G Williamson) Global Migration
and the World Economy: Two Centuries of Policy and Performance (MIT Press, 2005).
He is a Fellow of the IZA and of CEPR.
157
Playing politics with migration is dangerous but dangerously attractive in today’s climate
of European malaise. Nicolas Sarkozy, for example, tried to achieve new momentum in
his re-election campaign by calling for a revision of the Schengen Agreement. His goal,
obviously, was to win right-wing voters in the crucial first round of France’s two-step
election. His political and economic rationale, by contrast, remains opaque to say the
least.
• Is it an attempt to reduce migration particularly from the northern African countries?
• Or is it all about reducing illegal migration?
• Or is the intention of the French president to hinder the free mobility of workers and
other persons across the EU member states?
More generally, uncoordinated national policies are not the right way to govern
migration in an area as economically integrated as Europe. Uncoordinated policies
will give rise a prisoner’s dilemma situation where all members spend inefficiently
large amounts on border controls, sub-optimal asylum and humanitarian policies, and
inefficiently restrictive policies on legal migration.
What is Schengen?
The Schengen Agreement and the related legal framework – the “Schengen acquis” in
EU jargon – have three main dimensions (EC 2009):
• Removal of border controls for persons moving within the Schengen area
Tito Boeri and Herbert BrückerBocconi University and CEPR; IAB
A dangerous campaign: Why we shouldn’t risk the Schengen Agreement
Rethinking Global Economic Governance in Light of the Crisis
158
• Coordination on short-term visitors for third-countries’ citizens, i.e. the “Schen-
gen visa” that lets them travel freely within the Schengen area (applying only once
rather than for each Schengen country they want to visit).
• Coordination on border control measures vis-à-vis third countries and, when need-
ed, members’ border control measures supplemented and supported by other mem-
ber states (via the agency Frontex).
Critically, the Schengen Agreement also establishes information systems that facilitate
police cooperation among members, especially as concerns illegal migrants.
The benefits of the Schengen Agreement are obvious to travellers in Europe – it saves
time and money (by reducing information and transaction costs) for citizens and non-
citizens with Schengen visas. But there are other benefits:
• Schengen has gone hand in hand with an increase of net immigration to the Schen-
gen area – an increase not experienced by the countries outside the area. As Table
1 shows, non-Schengen nations have experienced a decline in immigration flows.
• Job opportunities offered by an individual country in the Schengen area are more
attractive as they come with the option of freely moving across the entire area.
• Schengen has also eased the conditions for doing business in Europe; travellers
from abroad perceive the Schengen area as a common market, which is much more
attractive to businesses than the fragmented situation before the agreement.
Table 1. Inflows of migrants, thousands of people
pre-Schengen (1985–95)
post-Schengen (1996–2007)
% Variation
European Countries not in the Schengen Area
2417.964 1130.986 -53%
Countries in the Schengen Area
12104.84 19393.5105 60%
Difference 113%
Source: OECD, International Migration Dataset.
A dangerous campagin: Why we shouldn’t risk the Schengen Agreement
159
Quantifying the gains of Schengen for businesses, consumers, and tourists is difficult,
if not altogether impossible. Given the high and increasing tendency of travelling all
over the Schengen countries and into the area, removing Schengen is like introducing a
tax on economic integration. It would also have negative consequences on the shaping
of a common European identity, hence on social and political integration just at a time
in which the public debt crisis and fiscal spillovers across jurisdictions require stronger
cross-country policy coordination in the EU.
Does Schengen increase illegal migration?
The Schengen Agreement does not reduce incentives for the enforcement of border
controls in each country. It actually encourages tight border controls vis-à-vis third
countries. According to the so-called Dublin II directive, the first EU nation a refugee
enters is responsible for the handling (and costs) of the asylum procedure (Hatton,
2005). This gives nations an incentive to shore up weak border protection on third-
nation borders. If refugees apply for asylum in other member countries, they will be
sent back to those countries where they entered the EU in the first place.
In this way, Schengen and the Dublin II directive created strong incentives for border
protection. It also meant, however, that certain members were providing a public good
– namely, border control – for the entire area. It is easy to identify such countries: Italy,
Spain, and Malta in the south; Poland, Bulgaria, and Romania in the east.
Migration pressures are particularly strong in the south and, here, Spain and Italy are
especially affected by illegal migration from sub-Saharan Africa and northern Africa. In
spite of the severe recessions experienced by southern Europe, the political revolution
and the subsequent economic downturn in northern Africa further increased these
pressures.
The figures of illegal migrants which entered Italy and Spain via the sea look rather
moderate compared to previous waves of immigrants fostered by political instability,
Rethinking Global Economic Governance in Light of the Crisis
160
for example in the Balkans. In Italy they were, on average, of the order of 20,000 per
year, except in 2011 when they jumped to about 50,000. Bilateral agreements with
northern African countries to prevent transit migration from sub-Saharan Africa and the
blood toll on the sea contributed to discourage larger flows. However, there are other
channels to entry so that actual figures might be much larger, and there are no data on
illegal migration across countries in the Schengen area.
Border controls are expensive and the treatment of asylum cases can be even more
costly. Italy is bound to spend more than €1 billion in 2012 just for the daily allowances
of asylum seekers who applied for this status in 2011. These costs are, in our view, a
critical issue and the threat to the sustainability of the Schengen Agreement.
The foul play of Berlusconi
Last year, the government headed by Silvio Berlusconi made a populist move
undermining the principles of the Schengen Agreement and the Dublin II directive. It
provided tourist visas to refugees and encouraged them to cross the border with other
countries, notably France. This clearly violates the purpose of the Dublin II directive.
Although these measures were withdrawn within a couple of days, they seriously
damaged cross-country cooperation in enforcing the Schengen Agreement. Well before
the Sarkozy campaign, the Danish government announced its intention to re-impose
controls on its frontiers with Germany and Sweden.
It should be stressed that the problem will not be solved by re-introducing border
controls. If the Schengen Agreement and the Dublin II directive are abolished, the
incentives for border protection in the most affected countries are reduced since
governments may hope that illegal migrants find their way to other EU countries if they
are sufficiently tough with migrants. This would create unfortunate knock-on effects – a
race to the bottom in humanitarian standards and high costs of border controls across
Schengen countries. Moreover, border controls for third-country nationals also require
A dangerous campagin: Why we shouldn’t risk the Schengen Agreement
161
border controls for citizens of the Schengen countries, and this would involve high
economic and social costs.
Sharing the costs of border controls?
The countries most affected by illegal migration perceive the other countries in the
Schengen area as free riders in terms of border controls. As mention, their third-nation
controls provide a public good for the whole area. A reform of the Schengen acquis
therefore has to address this issue. The most natural way to take these concerns into
account is to share at least some of the costs of border enforcement.
EU governments ought to acknowledge that cross-country spillovers of migration
policies are unavoidable. The case of the French-Italian border is not the first, nor will
it be the last. Here are a few precedents.
• Finland tightened up its restrictions on immigration in 2004, reacting to the more
restrictive stance taken by Denmark in 2002 which was inducing many more people
to go to Finland.
• Portugal adopted more restrictive provisions in 2001, just after a similarly restric-
tive reform implemented by Spain in 2000.
• Ireland chose a more restrictive approach in 1999, after two reforms in the UK that
had tightened up migration restrictions in 1996 and 1998.
The lesson from all of these episodes is that uncoordinated national policies cannot
govern migration. They can only give rise to a race to the top in putting nominal
restrictions on migration, systematically violated by illegal migrants coming in from
somewhere else. A coordinated policy for legal migrants at the EU level is warranted.
In this context, it would be wise also to consider a European asylum and humanitarian
policy, possibly integrated into a points-based system.
Rethinking Global Economic Governance in Light of the Crisis
162
Addressing the fundamental migration problems
At present, France and most other EU member states pursue a zero immigration policy
vis-à-vis the countries in the northern Africa. The consequence of these policies is that
family reunification, humanitarian migration, and illegal migration become the main
channels of entry. These immigrants are, on average, less educated than economic
migrants and natives, do not generally achieve native language proficiency and
typically have a poor performance in the labour market and education system of the
host country. This in turn feeds into negative perceptions of natives as to the fiscal costs
of immigration (Boeri, 2009), and makes economic and social integration more difficult
especially at times of slow growth, let alone deep recessions. These problems cannot be
addressed by a reform of the Schengen Agreement. They require a fundamental reform
of immigration policies, restoring a key role for labour migration.
Learning from the EU eastern enlargement
Per capita incomes in most northern African countries are not much lower than those
of the new EU Member States when they joined (Bruecker et al. 2009). While they
stand between 25 and 35% of GDP per capita in the EU measured at purchasing power
parities, the GDP of the new member states varied between 35 and 55% of those in the
EU15 when they joined. Moreover, substantial parts of the youth urban labour force in
north Africa are, at least on paper, relatively well educated. Thus, the experience of the
eastern enlargement of the EU can be rather instructive in assessing the consequences
of increased immigration from northern Africa.
From the eight new member states, which joined the EU in 2004, we have seen an
annual net migration inflow of about 210,000 persons, another 200,000 moved annually
from Bulgaria and Romania (Baas and Bruecker, 2012). The education levels of these
young migrants are similar or higher than those of natives, and in many countries their
unemployment rates are below the national average. According to our simulations, net
immigration from the ten new members so far generated an increase of GDP for the
A dangerous campagin: Why we shouldn’t risk the Schengen Agreement
163
(enlarged) EU of the order of 0.7%, or €74 billion. This result is not negligible in
times of slow growth in the entire EU area. More benefits will come as the assimilation
of immigrants proceeds and they get jobs fitting their competences, rather than
downgrading their skills.
Given the larger size and the slightly lower per capita income in the Mediterranean
countries neighbouring the EU, the economic gains from potential migration from
northern Africa are even larger. Clearly, it is much too early to consider a free
movement of workers from these countries similar to the eastern enlargement of the
EU. But adopting more realistic restrictions vis-à-vis northern African countries and
encouraging skilled immigration from Egypt, Tunisia, and other countries in that area
can reduce pressures for illegal migration and create substantial economic gains in both
the receiving and sending regions.
References
Baas, T., Bruecker, H. (2012), The macroeconomic impact of migration diversion:
Evidence from Germany and the UK, Structural Change and Economic Dynamics
(forthcoming),
Boeri, T. (2009), “Immigration to the Land of Redistribution”, Economica 77(308).
651-687.
Bruecker, H. et al. (2009), Labour mobility within the EU in the context of enlargement
and the functioning of the transitional arrangements, European Integration Consortium.
Hatton, T. (2005) European Asylum Policy, National Institute Economic Review 194
(1), 106-119.
EC (2009). “Official Journal of the European Communities - The Schengen Acquis”,
2009.
Rethinking Global Economic Governance in Light of the Crisis
164
About the authors
Tito Boeri is Professor of Economics at Bocconi University, Milan and acts as
Scientific Director of the Fondazione Rodolfo Debenedetti. He is research fellow at
CEPR, IZA and Igier-Bocconi. His field of research is labour economics, redistributive
policies and political economics. His papers have been published in the American
Economic Review, Journal of Economic Perspectives, Economic Journal, Economic
Policy, European Economic Review, Journal of Labour Economics, and the NBER
Macroeconomics Annual. He published 7 books with Oxford University Press and MIT
Press. After obtaining his Ph.D. in economics from New York University, he was senior
economist at the Organisation for Economic Co-operation and Development from 1987
to 1996. He was also consultant to the European Commission, IMF, the ILO, the World
Bank and the Italian Government. He is the founder of the economic policy watchdog
website www.lavoce.info and he is scientific director of the Festival of Economics,
taking place every year in Trento.
Herbert Brücker is Head of the Department for International Comparisons and
European Integration at the IAB since 2005 and Professor of economics at the
University of Bamberg since 2008. He completed a degree in sociology at the University
of Frankfurt in 1986 and attained subsequently his doctorate from the University of
Frankfurt in 1994. In 2005 Herbert Brücker received his habilitation in economics
from the University of Technology in Berlin. From 1988 to 2005 he held research
positions at the University of Frankfurt, the German Development Institute (GDI) and
the German Institute for Economic Research (DIW) in Berlin. Herbert Brücker was
Visiting Professor at the Aarhus School of Business from 2004 to 2005.
Edited by Richard Baldwin and David Vines
Rethinking Global Economic Governance in Light of the Crisis New Perspectives on Economic Policy Foundations
Rethinking global economic governance in light of the crisis: New perspectives on economic policy foundations
Global governance was, to put it charitably, one of the ‘steadier’ areas of economic research. Then the storm hit — the global crisis capsized existing concepts — pushing economists and political economists into uncharted waters.
For scholars, these horrible events were both daunting and exciting. Cherished assumptions had to be binned, but global governance became a top-line issue for heads of state. Economic and political analysis of global governance really mattered.
This Report collects a dozen essays by world-class scholars on the full range of global governance issues including macroeconomics, fi nance, trade, and migration. These refl ect the research of nine research teams working in an EU-funded project known as PEGGED (Politics, Economics and Global Governance: the European Dimensions).
Rethinking Global Econom
ic Governance in Light of the Crisis: N
ew Perspectives on Econom
ic Policy Foundations
top related